Tax implications for Corporation and Partnership
This brief memorandum provides information regarding the type of business entity in which to conduct a business enterprise, that is, Corporation or Partnership; advantages and disadvantages of their formation, income tax implications, and process of distributing income, sales and liquidation. This research includes comparative perspectives of both liability and tax implication for a Partnership and for a Corporation. Applicable Internal Revenue Codes and Regulations are thoroughly cited and applied in assessing and concluding facts. Calculations of tax liabilities and tax implication are based on assumed scenario explained below
Formation of Corporation
A Corporation is a legal entity separate from the person that forms it and includes associations, joint- stock companies and insurance companies as defined by code section 7701 (Smith, 2010). The main advantages of a Corporation are it can exist indefinitely and that it offers its owners the protection of limited personal liability.
First of all, shareholders A and B should file the article of incorporation to form the corporation. Pre-1997 classifications regulations listed following characteristics to distinguish a corporation for the tax purpose:
i) Association of two or more individuals who share controls.
ii) An objective to carry on business for profit.
iii) Continuity of life of business.
iv) Centralized Management
v) Limited Liability.
vi) Free transferability of interests.Assume that two shareholders A and B decide to form a Corporation and each of them transfers’ cash with a value of $500,000(Total $1,000,000) and basis of $500,000 (Total $1,000,000) in exchange for all of the corporation’s stocks.
The computation of amount and recognition of gain or loss in this transaction under code section 1001 is as follows:
| IRS Code Section | | Shareholders | Corporation |
| 1001(b) | Amount Realized | $1,000,000.00 | $1,000,000.00 |
| 1011(a) | Adjusted Basis | ($1,000,000.00) | $0.00 |
| 1001(a) | Realized Gain | $0.00 | $1,000,000.00 |
In theory, this transaction is no gain by the shareholders and a gain of $1,000,000 by the corporation in the ordinary course. However, code section 351(a) says that no gain or loss is recognized if property is transferred to corporation by one or more individuals, solely in exchange for stock if shareholders are in control of the corporation immediately after the exchange. Thus, this section is a common example of non-recognition provision (smith, 2010).
Therefore, this formation satisfies the requirement of code section 351(a) because they transferred property to the corporation solely for stock and they are in control of the corporation after the exchange under code section 368(c) because the shareholders have at least 80% ownership of all the stock outstanding. So, the shareholders do not have to recognize any gain under code section 351(a).
Similarly, under code section 1032(a), corporation will never recognize a gain for receiving cash or property in exchange for its stock (smith, 2010).
Formation of Partnership
Formation of partnerships is governed by Subchapter K of the code and they are treated as pass-through entities that do not pay federal income tax. Instead, partners include their respective shares of partnership income, deductions, losses, and other items when determining their tax liability as stipulated under code section 701 (Lind, Schwarz, Lathrope, & Rosenberg, 2010). Partnership, as a pass-through entity, has following features:
(1) Income generated by the business is taxed only once to the beneficial owners of the enterprise, whether or not they receive current distributions and,
(2) Losses pass-through to the owners, subject to various timing limitations 704(d), and may be deducted against income from other sources. Let us assume that that our client (A) and his partner (B) want to form a partnership by transferring appreciated cash with a value of $1,000,000 (each of them transferring $500,000) and a basis of $1,000,000.
In this process, the partner’s basis for his partnership interest shall be the carryover basis and the partnership’s basis for the contributed property would be also a carryover basis under code sections 722 and 723.
The computation of amount and recognition of gain or loss in this transaction under code section 1001 is as follows:
| IRS Code Section | | Partners | Partnership |
| 1001(b) | Amount Realized | $1,000,000.00 | $1,000,000.00 |
| 1011(a) | Adjusted Basis | ($1,000,000.00) | $0.00 |
| 1001(a) | Realized Gain | $0.00 | $1,000,000.00 |
In theory, this transaction has no gain by the partners and a gain of $1,000,000 by Partnership in the ordinary course. However, code section 721(a) says that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. Therefore, both partners and the partnership do not recognize any gain or loss while forming this partnership under code section 721.
Tax Implication of Corporation
Income from a Corporation is taxed twice, once at the corporate level when earned and again after distribution to the shareholders as dividends. The Corporation is treated as a separate taxable entity, distinct from its shareholders (Lind, Schwarz, Lathrope, Rosenberg, 2008). Therefore, transactions between Corporation and its shareholders are taxable. According to code section 11, the corporate income tax is essentially a 34% or 35% flat rate tax with no preferential rate for long term capital gains.
However, Corporations with smaller amounts of income can take advantage of lower tax rates (15% and 25%) on their first $75,000 of taxable income (code section 11(b)). Corporate shareholders can enjoy substantially lower tax rate of 15% on long term capital gain (code section 1(h)), however the dividend received by corporate shareholders under code section 316(a) is an ordinary income (code section 301(c)) and taxed as ordinary rate as explained under code section 61(a)(7). Exception, code section 1(h)(11)(A)(ii), the dividends received by the corporate shareholders are taxed at the same 15% maximum rate as long term gain until December 31, 2010.Assuming that earnings before tax of the JM corporation is $1,000,000.
Taxable Income = 1,000,000
Let’s assume corporate income tax is flat 35%, therefore, Tax liability = $1,000,000 X 35%
= $350,000.
Net income available to shareholders = $650,000.
Tax Implication of Partnership
According to code section 701 “Partners, not Partnership, subject to tax”, a Partnership business does not pay income tax but partners have to file their share of business profits or losses on their individual tax return. Therefore, income from partnership is single taxed.
Every individual, single or married has to pay tax based on their annual income at the rate beginning from 10% to highest rate up to 35%. A partner tax rate on their income is depends upon total income received by individual partner under code section 702.Let’s assume the same earnings before tax for the JM partnership business as the company earned that is $1,000,000. And, Partners have decided to distribute all the income.
Therefore, total taxable income for partnership = 0. (Refer Distribution section for Partners tax
rate on their individual income).
Distribution of Corporation
After JM corporation apply the annual income tax. The corporation has available $650,000, which can be decided to distribute to shareholders as dividends or reserve them as companies retain earnings. According to IRS, “qualified dividends are taxed at the same maximum rates that apply to a net capital gain. They are taxed at 15% if the regular tax rate that would apply is 25% or higher. They are taxed at 0% if the regular tax rate that would apply is lower than 25%” (IRS.gov, 2010). Let’s assume that JM corporation decides to distribute all profits to shareholders.
Tax consequences for corporation
Under code section 316(a), the dividend is a distribution of property to shareholders. If the amount is covered by earnings and profits of a current year as code section 316(a)(2), or out of earnings and profits since 1913 as code section 316(a)(1), the distributions are called dividend and need to apply 301(c)(1)(2)(3). (Fountain, 2010)
Let’s assume that this is the first year of JM corporation, the Corporation has $650,000 net income and decides to distribute 50% to A and another 50% to B.The distributions are considered as dividends under code section 316(a)(2). Under 301(c)(1), If the distributions are dividends, they are taxed as ordinary income under 61(a)(7).
1) The amount available to shareholder is $650,000 ($1,000,000 – $350,000 (35%) tax rate).
2) The individual tax will be $97,500 ($650,000 x 15%)
3) The net income available to shareholders will be $552,500 ($650,000 - $97,500).
4) Each shareholder will have a remaining distribution at $276,250.
Distributions for Partnership
JM partnership earned $1,000,000 profits this year and decide to distribute $500,000 each to A and B. Partners A and B need to include their distributed profits as an ordinary income at the end of the year.
Tax consequences for Partnership
According to the code section 701, “a partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities (Smith, 2010)”. As a result of this code section, JM partnership does not responsible for the distributed profits of $1,000,000, but A and B needs to include $500,000 for his individual income tax.
Continuing from code section 701, code section 702 (c) refers to “In any case where it necessary to determine the gross income of a partner for purpose of this title, such amount shall include his distributive share of the gross income of the partnership”. (Smith, 2010) Following by code section 704 (d), “A partner’s distributive share of partnership loss (including capital loss) shall be allowed only the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred”. (Smith, 2010) It indicates that the losses that occurred in a partnership can be offset against income from other sources.
A and B shall apply code section 1(i)(3) for the annual income tax. Under 1(i)(3), the distribution of $500,000 shall be taxed at 35%. Therefore, Tax liability for A and B = 500,000 X 35% = $175,000 each.
Sale of Corporation Stock
Since the JM corporation has formed under the section 351(a), which refers no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for its stock if shareholders are in control of corporation immediately after exchange. Therefore, shareholder A and B will not be recognized in the gain or loss from the solely in exchange for the JM corporation.
The main reason for this allowance is to encourage shareholder A and B to operate business. However, the gain for shareholder A and B that went unrecognized will be recognized if and when they sell the stock. As a result, the section 1001(a) will be applied for the sale of stock transaction as follow.
Code section 1001(a) complies the determination of the amount of recognition of gain or loss in the sale or other disposition of property shall be excess of the amount realized there from over the adjusted basis provided under code section 1011. (Smith, 2010)
Let’s assume that shareholder A and B sell all the JM corporation stocks to the third party at the total fair market value as $ 3 million.| IRS Code Section | | Shareholders |
| 1001(b) | Amount Realized | $3,000,000.00 |
| 1011(a) | Adjusted Basis | ($1,000,000.00) |
| 1001(c) | Realized Gain | $2,000,000.00 |
Note: This transaction occurs between the shareholders in Corporation and the third party. Therefore, Corporation does not impact from this transaction.
However, shareholder A and B will be taxed because this transaction creates the recognized gain to shareholder under code section 1001. Therefore, the code section 1(h)(1)(C) will be apply as 15% of tax rate for the maximum of capital gain. Each of shareholders pays $ 150,000 for the tax liability which from $ 2,000,000 x 15 % then divided by two, so it equal to $ 150,000 in each of shareholders. Therefore, each shareholder will have the money available as $ 850,000 from the sale of stock.
Sale of Partnership
A sale of the entity in the partnership means the partners sell their partnership interest. The transaction can be between the partner and a third party. Assuming the partners want to sell their partnership interest to the third party. Under section 741, in the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset.
Under code section 1001(a), the gain from the sale or other disposition of property shall be the excess of the amount realized there from over the adjusted basis provided in code section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided insection for determining loss over the amount realized. Generally, the sale or exchange of a partnership interest results in gain or loss, measured by the difference between the amount realized and the selling partner's adjusted basis in the partnership interest. (Smith, 2010)
As mentioned above, A and B each contributes $500,000 cash, total amount $1,000,000 to form JM partnership and a basis of $500,000 each and each partner will take 50% partnership interest in the JM partnership. Now, A & B sell their partnership interest to C for $3,000,000 cash.
The recognition gain or loss and tax would be calculated as follows:
The total amount realized – Adjusted Basis = Gain/loss
$3,000,000 - $1,000,000 = $2,000,000
Therefore, the recognition gain is $2,000,000. Under code section 741 mentioned above, such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset. The code section 1(h)(1)(C) complies in this transaction because the sale of partnership interest leads to the capital gain.
As a result, each partner pays $150,000 for the tax liability which from $2,000,000 multiples 15% then divided by two, so it is equal $150,000 to each partner. Eventually, each partner will get $850,000 in their pocket from selling the partnership interest.
Corporate Liquidation
According to the subchapter C of Chapter 1 defines the corporate liquidation as the dissolution of the entity in corporate form. The corporation pays the creditors and distributes the remaining assets to the shareholders. The shareholders surrender their stick to the corporation.
To deal with the liquidation that affects in the corporation is covered by code section 336(a) explaining that gain or loss shall be recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the distribute at its fair market value.
The corporation directly exchanges the assets for the shareholders’ stock. The corporation will recognize gain under code section 336(a) that the assets are sold at the fair market value. The amount of gain will be taxed, and after JM corporation pays debts the remaining will be distributed to shareholders.
Assuming, the buyers buy the building from JM corporation and give cash as $ 3,000,000 to Corporation.Corporation gain will be recognized under section 336 (a) as $ 2,000,000 @ 35 % (the tax rate for taxable income) which equal to $ 700,000. As a result, Corporation distributes $ 2,300,000 to shareholders.
| IRS Code Section | | Shareholders |
| 1001(b) | Amount Realized | $3,000,000.00 |
| 1011(a) | Adjusted Basis | ($1,000,000.00) |
| 336(a) | Realized Gain | $2,000,000.00 |
| Tax rate 35% | ($700,000.00) | |
| Net amount transferred to shareholders | $2,300,000.00 | |
The second taxed of Corporation occurs after JM corporation distributes cash to shareholders (dividend taxable) in exchange of stock from shareholders. Base on the code section 331(a), the amount received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock. Consequently, shareholders will recognize gain and will be fully taxed, assuming that the corporation has enough cash to pay for the recognized gain.
| IRS Code Section | | Shareholders |
| 1001(b) | Amount Realized | $2,300,000.00 |
| 1011(a) | Adjusted Basis | ($1,000,000.00) |
| 331(a) | Realized Gain | $1,300,000.00 |
| Tax rate 15% | ($195,000.00) | |
| Net amount transferred to shareholders | $2,105,000.00 | |
Therefore, shareholders gain will be recognized at 15% of maximum of capital gain under the code section 1(h)(1)(C). After shareholder A and B pay the capital gain tax , each of them will have $ 1,052,500 ($2,105,000 / 2 ).
Partnership liquidation
Liquidation of a partnership is not subject to double tax when distributing to a partner. Along with sales of partnership, a liquidating distribution completely terminates the partner’s interest from the business (Fountain, 2010).
According to a liquidation distribution means a partner terminates his or her interest as a partner, hence, the code section 701 apply the partnership doesn’t pay income tax, but partner shall be responsible for their income tax (Smith, 2010). So in the liquidation, the JM partnership makes a distribution or series of distributions to the partner under the code section 761(d) (Smith, 2010). Meanwhile, the partnership consider as ordinary income or as ordinary loss when the gain or loss on the disposition when partner distribute unrealized receivables under code section 735(a)(1) and as the same as inventory item which sold or exchanged within 5 years from the date of the distribution also considers as ordinary income or ordinary loss under section 735(a)(2)(Smith, 2010). Therefore, the gain is fully taxable under section 1001(a) (Smith, 2010).The statement for partnership as below:
Partner A and B decide to sell the asset of the partnership as fair market value of $ 3,000,000.As mentioned in the formation section, they had contributed $500,000 each at the time of establishment, therefore, total amount for JM partnership is $1,000,000. The basis of $500,000 each and partner has 50% partnership interest in the JM partnership.
Tax Consequence for A and B:
The recognition gain is equal to amount realized minus basis which is as follows: $3,000,000-$1,000,000=$2,000,000. Hence, the remaining cash of 2,000,000 is distributed to Partner A and Partner B equally because each of them have 50% partnership interest in the JM partnership. Finally, ordinary income of Partner A and B of $1,000,000 each will be taxed at 35 % under the section 735(a). Therefore, Tax liability of Partner A and B is $350,000 (1,000,000 X 0.35) each. As a result, each partner A and B will get gain of $ 650,000.
| IRS Code Section | | Partners | JM partnership |
| 1001(b) | Amount Realized | $1,500,000.00 | $3,000,000.00 |
| 1011(a) | Adjusted Basis | ($500,000.00) | $1,000,000.00 |
| 1001(c) | Realized Gain | $1,000,000.00 | $2,000,000.00 |
| Tax Rate | $350,000.00 | N/A | |
Note: each partner is taxable in the rate of 35% as ordinary income under section 61.
Considering all tax implications business entities, an entrepreneur has numerous options for the establishment of a business enterprise. Most commonly businesses are established as a Partnership or as Corporation. Each of this business entity has their own features and characteristics on the formation, tax implication, distribution of profits, sales and liquidation (partial or full) of business.
Generally, income tax treatment favors the selection of a Partnership as avoidance of double taxation. Limited liability for the shareholders strongly favors Corporation in case of business loss. In addition to this, Corporation kindles great ability on raising additional capital.
The process of sales and liquidation of business favor Partnership. The Corporation as a separate entity distinct from its shareholders, the process of sales and liquidation, and the overall tax implication, is more complex and costly.
Last but not the least, the nature of the business and ability and willingness of a businessperson to take risks significantly influence the decision concerning the type of business entity under which to form business. Professional tax consultant is looking forward to working with our clients and strongly encourages and recommends our clients to follow memorandum and Article of Association of Corporation and Undisputed Agreement of Partnership while choosing the entity.
