Question

Debra has operated family counseling practice for a number of years as a sole proprietor.She owns the condominium office space that she occupies in addition to her professional library an d office furniture. She has a limited amount of working capital and little need to accumulate additional business assets. Her total business assets are about $150,000, with an $80,000 mortgage on the office space being her only liability. Typically, she has business travel and charged assets at the end of the year. Debra has used her personal car for provided by the IRS. Over the last three years, Debra's practice has grown so that she now forecast $80,000 of income being earned this year. Debra has contributed small amounts reach the annual limits. Although she has never been sued, Debra recently has become rate her business to protect herself against being sued and to save taxes.

Required: You are good friend of Debra's and a CPA; she asks your opinion on incorporating her business. You are to meet with Debra tomorrow for lunch. Prepare a draft of the points you feel should be discussed over lunch about incorporating the family counseling practice.

Answer 1

The solution below presents the major points the students should bring up during the lunch discussion. Students should present in good format a memorandum containing some or all of the points that follow. The memorandum might be directed to the tax partner of the CPA firm for which the student works.

Nontax advantages

1. Limited legal liability. As a family counselor, Debra might want to form a professional association or professional corporation. The professional corporation would not insulate her against possibility liability for her professional actions but would provide limited liability for her other debts. Alternately, Debra might consider whether the limited liability company (LLC) form of doing business would provide an advantage over the S corporation form. The LLC form might allow Debra to avoid some of the S corporation shareholder and corporate restrictions. For tax purposes, however, the check-the-box regulations would treat a one-member LLC as a sole proprietorship.

2. Free transferability of interest. The corporate form might permit her to expand her family counseling business by taking in new “partners” who would be shareholders in her professional corporation, or enable her to form a partnership of the professional corporations of one or more family counselors.

3. Automobile expenses. The standard mileage rate can be used with the personal automobile even after incorporation. The automobile need not be transferred to the corporation at the time of incorporation. If planning incorporation, Debra should consider leasing the automobile to the corporation instead of continuing to use the standard mileage rate. Because her personal miles probably are substantially larger than her business miles, the current reimbursement method might prove simpler to operate.

4. Condominium ownership. The condominium need not be transferred to the corporation at the time of incorporation. If planning incorporation, Debra should consider leasing the condominium to the corporation instead of transferring it as a capital contribution. She may be able to deduct some or all of any tax losses experienced on the condominium ownership.

Tax advantages

1. Lower marginal tax rate. Double taxation associated with a C corporation would be avoided if the corporation made an S election or if Debra retained the sole proprietorship.

The C corporation, however, could provide an advantage by having the 15% or 25% rates apply to amounts retained in the business. However, if the corporation is a personal service corporation, it will be subject to flat 35% tax rate without the benefit of lower brackets.

A disadvantage of not operating as a C corporation is that the top two individual tax rates are near or equal to the top corporate tax rate.

2. Avoidance of double taxation by paying salaries and fringe benefits. Debra should consider paying herself a reasonable salary. This salary would be subject to the Social Security tax requirements for the employer and employee. However, it would eliminate part or all of the double taxation associated with a C corporation that pays dividends to its owners. However, dividends are taxed at the applicable capital gains rate. The total employment tax liability should be relatively close to what her self-employment tax liability was with the sole proprietorship. Although she would be a more-than-2% shareholder, she could claim fringe benefits, which would be treated as a salary payment (deductible by the corporation and taxable to the shareholder).

3. Section 1202 exclusion. Retention of C corporation status permits 50% of the gain recognized on the sale or exchange of small business corporation stock to be excluded from taxation under Sec. 1202. The exclusion is 100% for qualified stock acquired after September 27, 2010 and before January 1, 2015. The exclusion is not available for

S corporations. The benefit of the Sec. 1202 exclusion depends on the taxpayer’s tax bracket and the amount of the exclusion. For example, the following table compares regular capital gains tax rates with the effective Sec. 1202 rate (28% or 31.8% times the included portion). The incremental 3.8% net investment income tax rate applies for AGI exceeding $200,000 ($250,000 for married filing jointly).

Sec. 1202	Regular	Effective
Exclusion	CG Rate	Sec. 1202 Rate
50%	15.0%	14.0%
50%	18.8%	15.9%
50%	23.8%	15.9%
100%	15%-23.8%	0.0%

4. Retirement plan. Debra should consider establishing a qualified plan, such as a Sec. 401(k) plan, if she uses an S corporation or make periodic contributions to an IRA plan up to the contribution limit. Whether Debra has a part-time or full-time employee to handle her clerical requirements may impact her decision about the appropriateness of the various available “qualified” retirement plans.

5. Incorporation. Incorporation can occur with Debra and her new corporation recognizing no gain or loss. The corporation will recognize any uncollected accounts receivable from the proprietorship and can deduct any unpaid liabilities for expense items when it pays them. A carryover basis will apply for the assets transferred to the new corporation. The corporation would claim depreciation under the same methods and conventions used by the proprietorship. The basis in Debra’s stock would be a substituted basis referencing the basis of the assets transferred.

6. Tax year. A calendar year probably would be the simplest for either a C or an S corporation.

7. Accounting method. The cash method of accounting probably would be the simplest for either a C or an S corporation. If the C corporation qualifies as a personal service corporation or meets the $5 million gross receipts test, it can retain the cash method.

8. State and local taxes should be considered. Corporate entities may be subject to a state income tax liability even though they operate as S corporations.