Sole Proprietorships and Flow-Through Entities

1. Sole ProprietorshipsandFlow-Through Entities Chapter10

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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. 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)

11. 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

12. 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

13. 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

14. 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)

15. 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

16. 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

17. 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

18. 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

19. 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 default • Nonrecourse debt – creditor can look only to collateral for repayment on default

20. 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

21. 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

22. 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

23. 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)

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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)

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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)

39. 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

40. 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)

41. 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

42. 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

43. The End