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Sole Proprietorships and Flow-Through Entities. Chapter 10. Sole Proprietorship. One owner business that is easy to form Basis of personal assets contributed is lesser of adjusted basis or FMV Sole proprietor has unlimited liability - PowerPoint PPT Presentation
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10 - 2©2004 Prentice Hall, Inc.
Sole Proprietorship
One owner business that is easy to form Basis of personal assets contributed is
lesser of adjusted basis or FMV Sole proprietor has unlimited liability Sole proprietor does not receive a salary but
is taxed on the entire net income (or deducts the loss) from Schedule C on Form 1040
10 - 3©2004 Prentice Hall, Inc.
Sole Proprietorship
Some transactions are not included in business operating income Property transactions Charitable contributions
Sole proprietor not eligible for tax-free employee fringe benefits Can deduct own health insurance premiums for AGI Can deduct contribution to own retirement account
for AGI Can hire spouse as employee and spouse can then
participate in fringe benefits
10 - 4©2004 Prentice Hall, Inc.
Self-Employment Taxes
Self-employed individuals (sole proprietors, general partners, and managing members of LLCs) must pay self-employment taxes (Social Security and Medicare) Deduct 50% of tax for AGI S corporation shareholders are not subject
to self-employment tax
10 - 5©2004 Prentice Hall, Inc.
Partnerships
A partnership is a relationship between 2 or more individuals (or other entities)
No limit on number of partners There are no restrictions on who can be a
partner (any type of entity, including an individual, another partnership, a corporation, an estate, or a trust)
Most LLCs are partnerships for tax purposes
10 - 6©2004 Prentice Hall, Inc.
General Partnership
General partnerships have only general partners General partners are personally liable for all
debts of the partnership General partners have an active role in
management General partners have the authority to bind
the partnership with respect to third parties
10 - 7©2004 Prentice Hall, Inc.
Limited Partnership
Limited partnerships have at least one general partner and at least one limited partner Limited partner liability is limited to invested
capital Limited partners are not permitted to have
an active role in the management of the partnership
Limited partners do not have the authority to bind the partnership with respect to third parties
10 - 8©2004 Prentice Hall, Inc.
Limited Liability Partnership
The LLP is a general partnership that conducts a business providing professional services
Partners in an LLP are fully liable for the general debts of the partnership
This entity protects partners from liability for malpractice of other partners
10 - 9©2004 Prentice Hall, Inc.
Limited Liability Companies
LLC is a separate entity from its owners (members)
LLCs provide members with limited liability LLCs can choose to be taxed as partnerships or
corporations for federal tax purposes (or sole proprietorship if one-member LLC allowed)
Ownership structure allows different classes of ownership with different voting rights
Forming an LLC is a more formal process than a partnership and may be more costly
10 - 10©2004 Prentice Hall, Inc.
PLLC
The professional limited liability company is a type of LLC that allows the use of the LLC by professional service organizations
PLLCs protect members from liability for malpractice of another member
PLLCs protect members from general liabilities of the business (similar to corporate shareholders)
10 - 11©2004 Prentice Hall, Inc.
Self-Employed
General partners, managing LLC and other active LLC members are considered self-employed individuals and required to pay self-employment tax on net income passed through to them Limited partners and LLC members who are
only investors do not pay self-employment tax Partners and LLC members cannot be
employees and are not eligible for tax-free employee fringe benefits
10 - 12©2004 Prentice Hall, Inc.
Entity vs. Aggregate Concept
Entity concept – views the partnership as separate from the partners Partner can sell property to partnership and
recognize gain or loss on sale Aggregate or conduit concept – views the
partnership as an extension of the partners Partners are liable for debts of the partnership Partners share gains and losses from operations
10 - 13©2004 Prentice Hall, Inc.
Partner’s Interests
A partner has a proportionate interest in the partnership assets
A partner has a right to share in a percentage of the partnership's profits and losses Share of income or loss is determined by
whatever the partners have agreed to as contained in the partnership agreement
If the agreement does not specify, they are assumed to share profits and losses equally
10 - 14©2004 Prentice Hall, Inc.
Partnership Tax Year
Profits and losses flow through to partners on the last day of the partnership’s tax year Partners report their share on their tax return in
the year in which the partnership tax year ends Partnership tax year is one of following
Tax year of majority of its partners Year of all the principal partners (owning more
than 5% interest) Month that provides least aggregate deferral of
income Natural business year (no more than 3-month
deferral of flow-through items)
10 - 15©2004 Prentice Hall, Inc.
Operating Results
Form 1065, information return, includes Schedule K (K-1 for each partner) which shows separately stated items and aggregate income or loss Separately stated items are those that cannot
be aggregated into net income because they have some special treatment or limitation
Partnership net income is the aggregate of all items that are not separately stated
10 - 16©2004 Prentice Hall, Inc.
Separately Stated Items
Capital gains and losses Section 1231 gains and losses Dividends and interest (and related expenses) Section 179 deductions Charitable contributions Medical and dental expenses paid by
partnership for partners Passive income AMT preferences and adjustment items Self-employment income
10 - 17©2004 Prentice Hall, Inc.
Operating Results
Partners must report their share of partnership income even if they receive no distributions from which to pay taxes Partners who need money to pay taxes on
income that is passed through should make sure partnership agreement permits withdrawals of cash for this purpose
10 - 18©2004 Prentice Hall, Inc.
Partner's Basis
Basis determines the Maximum amount a partner can withdraw
tax-free from the partnership Limit on the amount of loss a partner can
deduct A partner's basis in his partnership interest
begins with his contribution to the partnership If property is contributed, the adjusted
basis of the property is used
10 - 19©2004 Prentice Hall, Inc.
Partner's Basis
The partner's basis is increased by: Partner's share of income (including tax-
exempt income) General partner's share of all partnership
liabilities (nonrecourse only for limited partners)Recourse debt – creditor can look to
general partners for repayment on defaultNonrecourse debt – creditor can look only
to collateral for repayment on default
10 - 20©2004 Prentice Hall, Inc.
Partner's Basis
The partner's basis decreased by Reduction in liabilities Partner's share of loss Distributions made to partner
Partner can never have negative basis To prevent negative basis, partner
recognizes gain equal to the amount a cash distribution exceeds basis
10 - 21©2004 Prentice Hall, Inc.
General Loss Limitation
If a partner’s share of losses exceeds the partner’s basis Partner can only deduct losses to the
extent of basis Excess losses are carried forward
(indefinitely) to future years until there is sufficient basis to deduct the unused losses
10 - 22©2004 Prentice Hall, Inc.
At-Risk Rules
Limits losses by recognizing partners are not at-risk for nonrecourse debt
At-risk rules limit deductibility of losses to partner’s basis reduced by nonrecourse debt Losses are carried forward until partner has
sufficient at-risk basis
10 - 23©2004 Prentice Hall, Inc.
Passive Activity Loss Rules
Sources of income and losses Active - wages & businesses in which
partner materially participates Portfolio - interest and dividends Passive - tax shelters, limited partnerships
& businesses without material participation Passive losses can only be used against
passive income (until year of disposal)
10 - 24©2004 Prentice Hall, Inc.
Material Participation
Current activity level 500 hours or more participation during year Participation is substantially all the activity by all
persons At least 100 hours and no one else participates
more At least 100 hours in more than one activity and
aggregate of activities exceeds 500 hours Prior activity level
Participated in 5 of preceding 10 years Participated in 3 prior years in personal service
activity
10 - 25©2004 Prentice Hall, Inc.
Rental Real Estate Relief
Taxpayers can qualify for up to $25,000 deduction for rental real estate losses
Taxpayer must own at least 10% and actively participate in management Set rents, qualify renters, approve repairs
Deduction phases out for AGI between $100,000 and $150,000
10 - 26©2004 Prentice Hall, Inc.
Real PropertyBusiness Exception
Taxpayers must spend more than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours
10 - 27©2004 Prentice Hall, Inc.
Guaranteed Payments
A fixed or guaranteed payment (or salary) made to a partner for services or use of capital is treated as a business expense deduction by the partnership and ordinary income to the partner receiving it
If the payments are dependent upon partnership operations, they are not guaranteed payments
10 - 28©2004 Prentice Hall, Inc.
Nonliquidating Distributions
Distributions are generally tax-free to partners
Distributions reduce the partner’s basis Reduce for cash received then for basis of
property received (partner takes partnership’s basis for property)
If cash distribution exceeds partner’s basis, the partner recognizes gain on the excess
Loss is never recognized on nonliquidating distributions
10 - 29©2004 Prentice Hall, Inc.
Liquidating Distributions
A partner may recognize loss if the total basis of cash and ordinary income property received is less than his partnership basis
If partner receives any other property, the partner allocates basis remaining in the partnership interest to that property (and loss is not recognized)
10 - 30©2004 Prentice Hall, Inc.
Sale of Partnership Interest
Any gain or loss recognized on sale of partnership interest is normally capital gain or loss If partnership owns ordinary income assets (hot
assets), the sale must be partitioned between the hot assets and all other assets to prevent the partner from converting gain on sale of ordinary income assets to capital gains
Any reduction in liabilities is treated as cash received
Partnership tax year closes for selling partner
10 - 31©2004 Prentice Hall, Inc.
S Corporations
Qualifying corporations that elect S corporation status use conduit concept resulting in only one level of tax
Profits allocated according to the number of shares of stock owned
Shareholders have limited personal liability
10 - 32©2004 Prentice Hall, Inc.
S Corporation Requirements
Must be a domestic corporation Have only one class of stock outstanding Have no more than 75 shareholders (counting
husband and wife as one) Have as shareholders only individuals, estates
and certain trusts Individual shareholders must be either U.S.
citizens or resident aliens
10 - 33©2004 Prentice Hall, Inc.
Electing S Status
File Form 2553 by 15th day of the 3rd month of the year in which election is to be effective File by March 15, 2004 for calendar year
2004 Prospective election (effective following tax
year) can be made any time IRS has authority to accept late filing if
corporation can show reasonable cause
10 - 34©2004 Prentice Hall, Inc.
Terminating S Election
Retroactive revocation must be by 15th day of 3rd month
If the S corporation fails to satisfy any of the S corporation requirements at any time, the election is terminated as of the day before the disqualifying event occurred
If termination inadvertent, IRS can allow to continue as S corporation
10 - 35©2004 Prentice Hall, Inc.
S Corporation Operations
Separately stated items are similar to partnerships
S corporation net income not subject to self-employment taxes Employment taxes paid only on salaries Cannot participate in employee fringe benefits if
greater than 2% shareholder
Form 1120S reports operations Income and loss allocated on number of days
ownership and number of shares owned
10 - 36©2004 Prentice Hall, Inc.
Loss Limitations
Similar limitations as for partners Shareholder must have basis Shareholder must be at-risk If losses are passive, passive rules apply
Liabilities very different from partnership Shareholder does not increase basis for any
corporate liability Shareholder can use basis of money shareholder
loaned to corporation to deduct losses
10 - 37©2004 Prentice Hall, Inc.
Stock Basis
Each shareholder must keep track of stock basis similar to tracking a partnership basis Basis begins with contribution to capital or
purchase of stock Increased for income and gains (including
nontaxable) and reduced for deductions and losses (but not below zero)
Distributions are tax-free if not in excess of basis and gain recognized if in excess of basis
10 - 38©2004 Prentice Hall, Inc.
AAA
Accumulated adjustment account – a corporate account that tracks a corporation’s undistributed but previously taxed earnings Can be distributed to shareholders without
additional tax Unlike basis, AAA may be negative from
losses (but distributions cannot make AAA negative)
10 - 39©2004 Prentice Hall, Inc.
Property Distributions
Shareholders use FMV for basis of property received
Corporation recognizes gain on distribution of appreciated property
Shareholders increase their stock basis for any gain recognized then reduce basis for the FMV of distributed property
10 - 40©2004 Prentice Hall, Inc.
Schedules M-1 and M-2
Schedule M-1 reconciles book to tax income and is similar to C corporation’s M-1 without contribution carryovers or taxes paid
Schedule M-2 reconciles AAA account at beginning of year to balance at end of year OAA reconciles items that don’t affect AAA
(tax-exempt income)
10 - 41©2004 Prentice Hall, Inc.
S Corporation Taxes
Under normal circumstances, an S corporation does not pay taxes
If it was previously a C corporation, it may pay taxes in a few special cases: Built-in-Gains Excess Net Passive Investment Income LIFO Recapture
10 - 42©2004 Prentice Hall, Inc.
Redemptions and Liquidations
S corporations follow C corporation rules In redemption of stock for property, S
corporation recognizes gain on distribution of appreciated property (but not loss)
Recognized gain flows through to shareholders
In liquidation both gains and losses can be recognized and flow through adjusting stock basis