Corporation versus Partnership

Strayer University
ACC317 Advanced Federal Taxation

December 7, 2013

Starting a business is not an easy task. First, one must decide what type of entity the business will be in an effort to maximize profits and reduce tax obligations as much as possible. The two entities I will discuss are corporations and partnerships. A corporation is defined as a legal entity that is separate and distinct from its owners. Corporations have most of the responsibilities and rights as individuals, however corporations have the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. (Investopedia, 1) Deciding to elect to become a corporation has advantages and disadvantages. A few advantages and disadvantages are listed below:
ADVANTAGES:
* Capacity to act as a legal entity * Due to many individuals investing funds, a corporation has a bigger source of capital which allows for larger business undertakings * Unlimited life which allows time to establish a strong credit position * Stockholders have limited liability for corporate debts. The extent of their investment in the corporation is all the stockholders are held liable for, personal assets are protected * Shares in a corporation can be transferred without prior consent from the corporation’s shareholders * Centralized management under a Board of Directors
DISADVANTAGES:
* Legal requirements are complicated and make the formation of a corporation difficult * Activities limited by the articles of incorporation * Subject to rigid government control * Possibility of abuse of powers by the Board of Directors * Restricts participation by stockholders The tax obligations of corporations can be difficult to calculate, but here is a brief overview. Shareholders in a corporation, as discussed earlier, are limited in their liability in the corporation, and shareholders are also limited on their tax obligation. Shareholders only pay taxes on any profits paid to them as salaries, bonuses or dividends. The corporation is responsible for paying federal taxes on any additional profits at the lower corporate tax rate. Tax liabilities for corporations in 2012 are as follows: Taxable Income Tax Rate | Not over $50,000 15% | Over $50,000 but not over $75,000 25% | Over $75,000 but not over $100,000 34% | Over $100,000 but not over $335,000 39%* | Over $335,000 but not over $10,000,000 34% | Over $10,000,000 but not over $15,000,000 35% | Over $15,000,000 but not over $18,333,333 38%** | Over $18,333,333 35% |
*Five percent of this rate represents a phaseout of the benefits of the lower tax rates on the first $75,000 of taxable income.
**Three percent of this rate represents a phaseout of the benefits of the lower tax rate (34% rather than 35%) on the first $10 million of taxable income. (Hoffman et al, 2014) In the practice set, the tax return for a C Corporation, No More Ice, Inc., was prepared. No More Ice, Inc is a manufacturing corporation that has gross sales of $6,173,837 in the year 2012. After all deductions and income is accounted for, the corporation No More Ice, Inc has taxable income of $145,611. The tax rate for this amount is 39%. The tax liability for No More Ice, Inc calculates to $56,788. No More Ice, Inc is owned by a married couple, Rupert (80% owner), and Josie (20% owner). Since No More Ice, Inc is a C corporation, the owners are not only required to pay individual federal income taxes for the corporation itself, but they also have to pay individual federal income taxes on their salaries. Had the couple elected No More Ice to be classified as a partnership, the couple would only have to pay federal income taxes once, claiming the profits from the business on their individual tax returns. If Rupert and Josie had elected partnership status, their profits would have only been taxed once and their tax liability would be less. The tax liability for a couple married filing jointly for 2012 with a taxable income of $145,611 would have been $28,550. That’s approximately half of what their tax liability is as a corporation. Although the tax liability would be less if No More Ice were categorized as a partnership, there would be less growth potential for the company. If I were CFO of No More Ice, Inc I would explain to my management team that profits from selling stock in the corporation would result in more investment in the corporation. More investment in the company provides funds to help expand the corporation. To help lower the tax liability, I would suggest increasing deductions such as charitable contributions or tax deductible improvements to the corporation. Now that corporations have been explained, I will now explain partnerships. Partnerships are taxed differently than corporations. Partnerships carry a lot more risk for the owners as well. A partnership is defined as a business organization in which two or more individuals manage and operate the business. All owners of a partnership are equally and personally liable for the debts of the business. The advantages and disadvantages of electing partnership status are as follows:

ADVANTAGES: * Business is easy to establish and start up costs are low * More capital is available for the business * Greater borrowing capacity * Opportunity for income splitting, an advantage of particular importance due to resulting tax savings * Partners’ business affairs are private * Limited external regulation * East to change legal structure later if circumstances change
DISADVANTAGES:
* The liability of the partners for the debts of the business is unlimited * Each partner is liable for their share of the partnership debts as well as being liable for all the debts * Risk of disagreements and friction among partners and management * Each partner is an agent of the partnership and is liable for actions by other partners * Complicated and costly if a partner decides to leave or a new partner joins The tax liability for owners of a partnership is pretty straightforward. The partnership itself is not a taxable entity. Each partner pays his or her own income tax on the percentage of profits they own in the company. For example, in the practice set for Walk Upright Company, the two owners, Thomas and Lucy March shared the federal income tax liability according to their ownership in the company. Taxable income for the company equals $368,292. Thomas owned 70% and Lucy owned 30% of Walk Upright Company. Thomas’ share of taxable income is $257,804. Lucy’s share of taxable income is $110,488. Each partner would claim this amount on their individual tax returns at the tax rate for their computed tax bracket. If I were CFO of Walk Upright Company, I would explain to my management team that electing to be a partnership is best with regard to tax liability. The gross sales of the company is not a large amount of money, and if Walk Upright Company was classified as a corporation, double taxation would take even more of the profits which would result in lower salaries for employees. Converting from one business entity to another can have tax consequences depending on the type of entity conversion. Some conversions can be tax-free, while others may trigger income tax liability. For example, a partnership can convert to a corporation with few tax ramifications. The partners retain their ownership interests in the new entity. However, converting a corporation to a partnership is not so easy. In order for the conversion to take place, the corporation is treated as if they had closed their doors and liquidated all assets. Also, this transaction is taxable to both the corporation and the shareholders. Here are four steps to follow when changing business structures that will guarantee a successful and smooth transition: 1. Register with Local and State Agencies. To convert to a sole proprietorship or partnership, file a DBA or 'fictitious name' registration form with your government agency if you plan to operate under a name other than the owners' legal name. To convert to an LLC or corporation, you must file the articles of incorporation and other paperwork with your state government office. 2. Register with the IRS. You will most likely need to apply for a new Employer Identification Number (EIN). If you convert to a corporation, you must file for a new EIN, unless you elect to file as an S-Corporation. Corporations converting to sole proprietorships or partnerships also must apply for a new EIN. Use this checklist from IRS.gov to determine if you need a new EIN. You can learn more about EINs at Business.gov. 3. Reapply for Licenses. Some states require you to reapply for licenses when your business structure changes. For example, Minnesota requires plumbing contractors to reapply. Find out about your state's licensing requirements at Business.gov. 4. Spread the Word. Notify your bank and insurance company of the change. Your bank may require you to transfer assets. Also, make sure you inform everyone you do business with, including suppliers, customers and employees, if the change affects them in any way.

References

Griffin, D. (n.d.). What Are the Advantages & Disadvantages of Forming a Corporation? | Chron.com. Retrieved December 7, 2013, from http://smallbusiness.chron.com/advantages-disadvantages-forming-corporation-3896.html

HOFFMAN, W. H., MALONEY, D. M., RAABE, W. A., & YOUNG, J. C. (2014).SOUTHWESTERN FEDERAL TAXATION (2014 ed.). MASON, OHIO: CENGAGE LEARNING.

Investopedia (n.d.). Corporation Definition | Investopedia. Retrieved December 7, 2013, from http://www.investopedia.com/terms/c/corporation.asp