Taxation of Alternative Forms of Business

1
Taxation of Alternative Forms of Business

• Proprietorship
• Not a separate legal entity
• Income reported by and taxed to proprietor
• Partnership
• Separate legal entity, but not a taxable entity
• Partnership files information return
• Income reported by and taxed to partners when
  earned by the partnership

2
Taxation of Alternative Forms of Business
continued

• Corporation
• Separate legal entity
• C corporation
• Taxable entity income reported by and taxed to
  the corporation
• Dividend distributions are not deductible by the
  corporation, and are taxable income to the
  recipient shareholders
• Increases in value of shares taxed as capital
  gains when stock is sold

3
Taxation of Alternative Forms of Business
continued

• S corporation
• Not a taxable entity files an information
  return
• Income reported by and taxed to shareholders when
  earned by the corporation
• Limited to 75 non-corporate shareholders
• Limited Liability Company (LLC)
• Generally elect to be taxed as partnerships

4
Calculating After-Tax Business Accumulations

• Some more notation
• tp partner-level tax rate on ordinary income
• tc corporate income tax rate
• Rp before-tax return on partnership investment
• rp after-tax rate of return on partnership
  earnings Rp(1 tp)
• Rc before-tax return on corporate investment
• rc after-corporate-level-tax (but before
  shareholder-level tax) rate of return on
  corporate earnings Rc(1 tc)
• ts effective annualized tax rate on shares

5
After-Tax Partnership Accumulation

• Assume that partnership distributes cash each
  year to the partners sufficient to pay tax, then
  reinvests remaining after-tax earnings for n
  periods, then liquidates
• After-tax accumulation I1
  Rp(1-tp)n(same as IV1 from Chapter 3)

6
After-Tax Corporate Accumulation

• Assume that corporation makes no dividend
  distributions it reinvests all
  after-corporate-tax earnings for n periods, then
  liquidates
• After-tax accumulation I1 Rc(1 tc)n
  (1-tcg) tcgI(similar to IV2 from Chapter 3)

7
Choice of Partnership or Corporate Form

• Assuming Rp Rc, difference in after-tax
  accumulations depends on tp, tc, tcg, and n
• If tp tc and tcg 0, after-tax accumulations
  are identical
• If tp tc and tcg gt 0, the partnership form
  dominates the corporate form for all n
• If tp gt tc and tcg 0, the corporate form
  dominates the partnership form for all n
• If tp gt tc and tcg gt 0, either form may be
  preferred

8
Choice of Form continued

• Why might Rp ? Rc?
• Liability issues
• Administrative and reporting cost differences
• Access to capital
• Owner control over management

9
Comparing Partnership and Corporate Forms when Rp
? Rc

• One approach find a rate of return to corporate
  form at which investor is indifferent
• rc (1rp)n tcg/(1 tcg)1/n 1
• For any given set of tax rate variables and time
  horizon, can solve for rc using the above
  formula. Then solve for the required before-tax
  rate of return, Rc, using Rc (1 tc) rc
• For any Rc gt Rc, corporate form preferred
  otherwise, partnership form preferred

10
Example

• Let Rp 10, tp 40, tc 35, tcg 20, and
  n 5. Then rp 10(1 - 40) 6
• rc 1.065 - .20/(1-.20)1/5 1 0.073
  or 7.3
• Rc 7.3/(1 - .35) yields Rc 11.2
• Interpretation The corporation must produce a
  before-tax rate of return 1.2 higher than the
  partnership, to overcome its tax disadvantage

11
Example continued

• Suppose n 25.
• rc 1.0625 - .20/(1-.20)1/25 1 0.067
  or 6.7
• Rc 10.3
• Interpretation Over a longer time horizon, the
  tax deferral of the lower capital gains tax on
  the corporate liquidation becomes more valuable,
  and the required corporate before-tax rate of
  return is only .3 higher than the partnership
  return

12
Example continued

• Finally, suppose n 50
• rc 1.0650 - .20/(1-.20)1/50 1 0.064
  or 6.4
• Rc 9.8
• Interpretation Over a very long time horizon,
  the corporation is preferred to the partnership
  even with a lower before-tax return. Why? The
  annual corporate tax rate is lower than the
  annual partnership tax rate, and the capital
  gains tax is deferred 50 years.

13
Effective Annualized Tax Rate on Shares

• Example showed that increased deferral of capital
  gains taxation reduces the required corporate
  return
• One way to calculate the impact of such deferral
  is the effective annual tax rate the rate of
  annual taxation on increased corporate value at
  which the shareholder would end up with the same
  after-tax accumulation
• ts 1 rp/rc

14
Example continued

• When n 5, rc 7.3, and ts 1 - .06/.073
  17.8
• When n 25, rc 6.7, and ts 1 - .06/.067
  10.4
• When n 50, rc 6.4, and ts 1 - .06/.064
  6.3
• Interpretation?

15
Comparisons of Corporate and Partnership Forms
over Time

• Review Table 4.4 in text
• How were these numbers calculated?
• I would use
• rc (1rp)n tcg/(1 tcg)1/n 1
• Rc rc/ (1 tc)

16
Required Corporate Return with Dividends

• Recall our initial assumption that the
  corporation pays no dividends
• Would we expect the payment of dividends to
  increase or decrease the required corporate rate
  of return, relative to the partnership? Why?
• We can incorporate dividends into the equation
  for rc, but we wont do so

17
Other Complications

• Corporate and individual tax rates are not
  constant
• Vary across taxpayers, given progressive rate
  structures
• Vary across time
• Rates of return are not constant over time
• Corporate net operating losses and
  carryback/carryover rules affect timing of
  taxation

18
Other Complications continued

• Different types of investors have different tax
  characteristics and thus different rates
• Fully taxable individual investors
• Tax-exempt investors (pension funds, non-profit
  organizations)
• Corporations
• Foreign investors
• Broker-dealers

19
Other Organizational Forms and Their Tax
Characteristics

• Foreign subsidiaries
• Closely held corporations
• Not-for-profit corporations
• Tax-imputation corporations
• REITs
• REMICs