Sole Proprietorships and Flow-Through Entities

Sole ProprietorshipsandFlow-Through Entities Chapter10

Flow-Through Entity • An operating business whose net income (and certain other items) passes directly through to the owners • The items passed through are included with the owners’ other income/loss items for taxation

Flow-Through Entities • Sole proprietorship • General partnership • Limited partnership • Limited liability company (LLC) • Limited liability partnership (LLP) • S corporation

Sole Proprietorship • One owner business that is easy to form • Owner (sole proprietor) must be an individual • Sole proprietor has unlimited liability • Business uses same tax year as owner • Owner has no capital account and no basis in the business as a whole • Basis of personal assets contributed is lesser of their adjusted basis or FMV • Owner must establish that the business is legitimate and not a hobby

Sole Proprietorship • Owner uses Schedule C (or C-EZ) to report proprietorship income and expenses • Some transactions are not included in business operating income • Investment income and expenses • Capital gains and loses • Section 1231 gains and losses • Charitable contributions

Sole Proprietorship • When proprietor maintains an office in the home • Allocated space must be used exclusively and on a regular basis for the business • Deduction is limited to taxable income from business after deducting all other business expenses • Expenses related to use are separately reported on Form 8829

Sole Proprietorship • Sole proprietor does not receive a salary • Taxed on the entire net income (or deducts the loss) from Schedule C on Form 1040 • Sole proprietor is 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

Self-Employment Taxes • Self-employed individuals (sole proprietors, general partners, and managing members of LLCs) must pay self-employment taxes (Social Security and Medicare) • Deduction allowed for 50% of self-employment tax for AGI

Partnerships • A partnership is a relationship between 2 or more individuals (or other entities) to operate a business and share profits • No limit on number of partners • 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

General Partnership • General partnerships have only general partners • General partners: • Are personally liable for all debts of the partnership • Have an active role in management • Have the authority to bind the partnership with respect to third parties

Limited Partnership • Limited partnerships have at least one general partner and at least one limited partner • Limited partners: • Liability is limited to invested capital • Are not permitted to have an active role in the management of the partnership • Do not have the authority to bind the partnership with respect to third parties

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, however

Limited Liability Company • An 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 (single-member LLC cannot be taxed as partnership) • Ownership structure allows different classes of ownership with different voting rights • Forming an LLC is a more formal process than forming a partnership and may be more costly

PLLC • The professional limited liability company is a professional service organization using the LLC form • PLLCs protect members from • Liability for malpractice of other members • General liabilities of the business (similar to corporate shareholders)

Partners Cannot Be Employees • General partners, managing LLC, and other active LLC members are considered self-employed individuals and are 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

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

Partner’s Capital Account • Each partner’s capital account will show the partner’s claim on the net book value of the partnership assets • The difference between the partner’s capital account and partner’s tax basis is due to the unrecognized (deferred) gain or loss on property contributed

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 the provisions of the partnership agreement • If no provision is specified, partners are assumed to share profits and losses equally

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 its partners who own majority interest • 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)

Operating Results • Form 1065, information return, includes Schedule K (and 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 are subject to some special treatment or limitation at the owner level • Partnership net income is the aggregate of all items that are not separately stated

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

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

Partner's Basis • Basis determines • 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, partner’s basis equals the adjusted basis of the property contributed

Partner's Basis • The partner's basis is increased by: • Partner's share of income (including tax-exempt income) • Recourse debt— creditor can look only to general partners for repayment on default • Nonrecourse debt— creditor can look only to collateral for repayment on default • Partner’s share of liabilities • General partner's share in all partnership liabilities • Limited partner’s share in nonrecourse liabilities

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 by which a cash distribution exceeds basis

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 against which to deduct the unused losses

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 minus nonrecourse debt • Losses are carried forward until partner has sufficient at-risk basis

Passive Loss Rules • The rules limit deduction of losses by passive investors, such as limited partners • Passive losses can only be deducted against income from other passive investments • Passive losses cannot be deducted against active income (including salaries) or portfolio income (interest & dividends)

Partner’s Guaranteed Payment • 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

Nonliquidating Distributions • Distributions are generally tax-free to partners • Distributions reduce the partner’s basis • Reduce basis first for cash received then for basis of other property distributed (partner takes partnership’s basis for property) • If cash distribution exceeds partner’s basis, the partner recognizes gain for the excess • Loss is never recognized on nonliquidating distributions

Liquidating Distributions • Gain recognized only if cash received exceeds partner’s basis (same as nonliquidating distribution) • A partner may recognize loss only 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)

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

S Corporations • Qualifying corporations that elect S corporation status use conduit (flow-through) concept to achieve only one level of tax • Profits and losses allocated to shareholders according to the number of shares of stock owned on each day of the tax year • Afford shareholders the limited personal liability of a regular corporation

S Corporation Requirements • Must be a domestic corporation • Have only one class of stock outstanding • Have no more than 100 shareholders (family members are considered one shareholder) • Can have only individuals, estates and certain trusts as shareholders • Individual shareholders must be either U.S. citizens or resident aliens

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, 2006 for calendar year 2006 • Prospective election (effective for following tax year) can be made any time • IRS has authority to accept late filing if corporation can show reasonable cause

Affirmative Terminationof the S Election • A retroactive revocation must be made by the 15th day of 3rd month by a simple majority of the shareholders • A prospective termination can be made at any time for any future date specified by a simple majority of the shareholders

Inadvertent Terminationof the S Election • 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 • For example, exceeding the 100 shareholder limit • If termination inadvertent, IRS can allow corporation to continue as S corporation

S Corporation Operations • Determination of net income and separately stated items is similar to partnerships • S corporation net income not subject to self-employment taxes • Employment taxes paid only on salaries • Shareholder cannot participate in employee fringe benefits if ownership is greater than 2% • Form 1120S reports operations • Income and loss allocated on number of days ownership and number of shares owned

Loss Limitations • Limitations on loss deductions for shareholders similar to those for partners • Liability treatment very different from partnership • No basis increase for any corporate liability • Shareholder can deduct loss to the extent of basis in debt for money loaned directly to corporation

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 • Reduced first for distributions and then for deductions and losses (including nontaxable income and expenses), but not below zero • Distributions are tax-free if they do not exceed basis; gain recognized if distribution exceeds basis as if stock is sold for excess

AAA • Accumulated adjustment account – a corporate account that tracks a corporation’s undistributed but previously taxed earnings • The positive balance in AAA is the measure of the value of cash and property that can be distributed to shareholders without additional tax • Unlike basis, AAA may be negative from losses (but distributions cannot make AAA negative)

Property Distributions • Corporation • Recognizes gain on distribution of appreciated property • Does not recognize loss on depreciated property • Shareholders • Increase their stock basis for the gain recognized • Basis is then reduced for FMV of distributed property • Unrecognized loss reduces basis, however • Shareholders use FMV for basis of all property received

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 do not affect AAA (tax-exempt income and expenses)

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 for • Built-in-Gains • Excess Net Passive Investment Income • LIFO Recapture

Redemptions and Liquidations • S corporations follow C corporation rules • In a redemption of stock for property, S corporation recognizes gain on distribution of appreciated property (but not loss) • Recognized gain flows through to shareholders and increases basis • In liquidation, both gains and losses are recognized; these gains (losses) flow through and increase (decrease) stock basis

U.S. Production Activities • Deduction in 2005 is 3% of income from qualifying U.S. production activities • Deduction determined at the owner level based on owner’s share of qualifying production activities income • Limitation based on 50% of W-2 wages paid is determined at entity level

Passive Income and Losses • Passive losses can only be deducted by owner/recipient to the extent there is passive income from a prior year or from another passive activity • Passive losses may be deducted against nonpassive income in year activity is completely disposed of

Types of Income and Losses • Active – salary and wages of an employee and income earned from a business in which the owner/recipient materially participates • Portfolio – interest and dividends • Passive – tax shelter income, income passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate

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 • Materially participated in 5 of preceding 10 years • Materially participated in 3 prior years in personal service activity

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 AGIs between $100,000 and $150,000

Sole Proprietorships and Flow-Through Entities