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Sole Proprietorshipsand

Flow-Through Entities

Chapter 10

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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)

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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

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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

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The End