Chapter 10

1. Chapter 10 Sole Proprietorships, Partnerships, LLCs, and S Corporations

2. Objectives • Explain effect of a sole proprietorship on an individual tax return • Compute FICA taxes and self-employment taxes • Differentiate between partnership distributive income versus cash flow • Apply basis limitation on deduction of partnership losses • Explain federal tax treatment of Limited Liability Companies (LLCs) • Compute partnership adjusted basis • Determine eligibility for S Corporation status • Contrast basis limits for S Corporations versus partnerships

3. Business Organizations • Taxpayer = owner(s) of flow-through entities • Sole proprietorship • Partnerships • LLCs • S Corporations • Taxpayer = corporation • C Corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxation

4. Sole Proprietorship • Business income and expenses are reported on Schedule C, filed with the individual form 1040 • Net income or loss on Schedule C is ordinary income or loss; combine this net amount with other items of gross income on page 1 of form 1040 • If the Schedule C business lossis greater than other sources of income, the NOL (net operating loss) can be carried back 2 yearsand forward 20 years

5. Sole Proprietorship • Special reporting rules • Interest, dividends and rent income related to owner’s investments are not reported on Schedule C; see Schedules B and D instead • Dispositions of business assets are reported on Forms 4797 and Schedule D • Interest expense on business debt isdeducted on Schedule C. Non-businessinterest expense may be deductible if it is for investments or home mortgages. More on this issue in Chapters 15 and 16

6. Home Office Deduction • A portion of the taxpayer’s personal residence may be allowable as a Schedule C deduction if • The office is used exclusively on a regular basis • 1) as the principal place of business operated by the homeowner, OR • 2) as a place to meet with patients, clients or customers • A home office used exclusively for administrative or management activities qualifies if the taxpayerhas no other fixed location where such activities are conducted

7. Home Office Deduction • If the home office qualifies • Allocate expenses between business and personal use • Utilities • Home mortgage interest and taxes • Insurance • Repairs • Depreciation • Home office deduction cannot exceed taxable income of the business before this deduction

8. Employment Taxes • FICA = 6.2% Social Security tax (on wages up to $94,200 in 2006, $97,500 in 2007) + 1.45% Medicare tax on all wages; both employer and employee must pay this tax • Employers withhold income taxes and the employee’s share of FICA taxes • Employers must remit the withheld taxes to the federal (and state if applicable) governments

9. Employment Tax Example • In 2007, ABC Co. paid Ms. Smith $99,000 in salary and withheld $10,450 for federal income taxes. How much cash was disbursed to Ms. Smith and to the US Treasury on her behalf? • Ms. Smith’s Social Security W/H = (.062 x $97,500) = $6,045 • Ms. Smith’s Medicare W/H: (.0145 x $95,000) = $1,436 • Cash disbursed to Ms. Smith = $99,000 - $10,450 - $6,045 - $1,436 = $81,069 • Cash disbursed to US Treasury = $10,450 + ($6,045 x 2) + ($1,436 x 2) = $25,412

10. Self-Employment (SE) Tax • Self-employed persons pay SE tax on net earnings from self employment • Tax base = 92.35% of net profit reported on Schedule C • Tax rates • Social security tax =12.4% of earnings up to $97,500 (2007) • Medicare tax = 2.9% of earnings • Self-employment tax is paid via estimated tax payments rather than through withholding • 50% of SE tax deductible on Form 1040 as deduction for AGI

11. Partnerships • The partnership agreement states the rights and obligations of partners, and the % of profits and losses allocable to each partner. Such agreements permit flexibility • General partnership: all partners haveunlimited liability - joint and severable • Limited partnership: one or more limited partners are only liable for their contributed capital. Legally, all limited partnerships have at least one general partner

12. Limited Liability Partnership • Limited liability partnership (LLP) used for professional services. General partners are not liable for malpractice of other partners but are personally liable for other debts of the LLP

13. Initial Tax Basis in Partnership Interest • Cash plus adjusted basis of property contributed • + Share of partnership debt for which partner could be responsible • Two individuals, Jay and Kay, each contributed $25,000 cash to a new partnership. What is Jay’s basis in his partnership interest assuming that the partnership takes out a $10,000 loan and • The partnership assets secure the loan? • ($25,000 + (.5*$10,000)) = $30,000 • Jay personally guarantees the loan? • $25,000 + $10,000 = $35,000

14. Partnership Reporting • The partnership files an information return, Form 1065 • Included with Form 1065 are Forms K-1, which show each partner’s ‘distributive share’ of income and deductions • “Non-ordinary” items are separately stated and retain their character on the partner’s return • Examples: muni interest, capital gains and losses • Each partner reports his or her share of partnership income on Schedule E, as part of his or her Form 1040

15. Partnership Reporting • Because the partnership does not pay tax, the partnership is referred to as a ‘flow-through’ or ‘pass-through’ entity • Publicly Traded Partnerships • Partnership interests traded on an established securities market • Generally taxed as corporations

16. Guaranteed Payments • A guaranteed payment is a special allocation of ordinary income to the partner receiving it; similar to a salary, except that FICA and income tax are not withheld • Partnership is allowed a deduction for the guaranteed payment • The receiving partner reports as ordinary income • 1) His guaranteed payment and • 2) His share of partnership income after the guaranteed payment • Other partners report their shares of partnership income after the guaranteed payment

17. Guaranteed Payment - Example • Robert, John and Joseph form the RJJ partnership. Robert will do most of the work, so he will receive a guaranteed payment of $25,000 per year. The partners agree to share any remaining income one-third each • The partnership earns $85,000 during the year • Robert reports $45,000 of partnership income ($25,000 + 1/3 x $60,000) • John and Joseph each report $20,000 of partnership income (1/3 x $60,000)

18. Self-Employment Income From Partnership • SE tax must be paid by a general partner on • Guaranteed payments + • Distributive share of ordinary business income from partnership • Limited partners do notpay SE tax on their shareof ordinary income

19. Adjusting Partnership Basis • A partner’s tax basis in his/her partnership interest is adjusted annually to reflect share of partnership items and changes in investment • These items increase basis • Contributions (initial and ongoing): cash + adjusted basis of property contributed • Positive income (taxable and tax-exempt) • Share of partnership liabilities for which partner is liable (Also allow nonrecourse real estate loans for limited partners)

20. Adjusting Partnership Basis • These items decrease basis • Distributions • Losses and deductions (and shares of nondeductible expenses

21. Partnership Losses Limited to Basis • Partners cannot deduct losses in excess of basis • Excess losses are carried forward indefinitely until additional basis is restored either by additional contributions or additional positive income • This rule applies to each partnership separately

22. Partnership Losses Example • Mr. Q is a 1/3 partner in QRS Partnership. His basis in the partnership at the beginning of the year is $3,000. The partnership had ordinary income of $30,000; capital gain of $4,500; and guaranteed payments to Mr. Q of $45,000 for the current year • Mr. Q’s share of the operating loss is (1/3 * ($30,000 - $45,000) = $5,000, but the current year deduction is limited to basis • What is Mr. Q’s basis as of Dec. 31? • Beg. of Year Basis $ 3,000 • Share of capital gain 1,500 • Share of operating loss ( $4,500) • End of Year Basis $ 0

23. Limited Liability Company • LLCs are an alternative to a general or limited partnership. All members of an LLC have limited liability for LLC’s debt • Treated as a corporation for liability purposes, but as a partnership for federal tax purposes • Relatively new organizational form - less legal precedence • Every state (and DC) permits LLCs • Still unclear whether LLC income is subject to SE tax

24. S Corporations • Legally a corporation under state law, an S Corporation is a flow-through entity for tax purposes • Income and loss items are allocated among shareholders based on their % ownership of stock; this allocation is not flexible like partnership agreements • Flow-through items retain their character (e.g. ordinary income, capital losses, charitable contributions, etc) • Distributions to S corporation shareholders are generally treated as non-taxable recoveries of investment, similar to partnership distributions • Not treated as dividends (C corporation treatment)

25. S Corporation Eligibility • Only individuals, estates and some trusts may be shareholders – not nonresident aliens, other corporations, or partnerships • The number of shareholders is limited to 100; all family members may be counted as 1 shareholder • The corporation may only have one class of outstanding common stock • Shareholders must unanimously elect S Corp status; the election is permanent unless shareholders owning a majority of the stock revoke the election

26. Shareholder Basis • Initial basis = cash + adjusted basis of contributed property • Loan from a shareholder to S Corp increases basis for that shareholder. Any other debt of the S Corp does not increase shareholder basis (E.g., a bank loan guaranteed by shareholder does not increase basis for any shareholder, even the one that guaranteed the loan) • Like partnerships, basis is increased by contributions and income items; basis is decreased by distributions and loss items

27. S Corporation Operation • Shareholders can be paid a salary • Salary is subject to payroll taxes and reduces ordinary income of the S Corporation • S Corp can use corporate employee benefit plans for shareholder/employees • Share of ordinary income is NOT subject to Self-Employment tax

28. S Corporation Operation • Allocable share of loss items can only be deducted up to basis, as with partnerships • If the shareholder loans money to the S corporation, additional loss equal to the basis of debt may be taken • Losses in excess of basis are carried over until the shareholder has basis again

29. S Corporation Loss Example • Assume that Mr. Q owns 1/3 of the stock in an S Corporation and that the basis in his stock on Jan. 1 is $3,000. In addition, Mr. Q loaned the S corp. $1,000 during the year. The S Corp. had ordinary income before salary payments to Mr. Q of $30,000; capital gain of $4,500; and salary payments to Mr. Q of $45,000 for the current year. Stock Loan • Beg. of Year Basis $ 3,000 $1,000 • Share of capital gain 1,500 - • Share of operating loss ( $4,500) ($ 500) • End of Year Basis $ 0 $ 500