Sole Proprietorships and Flow-Through Entities

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Sole ProprietorshipsandFlow-Through Entities

• Chapter 10

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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

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Flow-Through Entities

• Sole proprietorship
• General partnership
• Limited partnership
• Limited liability company (LLC)
• Limited liability partnership (LLP)
• S corporation

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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

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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

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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

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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

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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)
• Deduction allowed for 50 of self-employment tax
  for AGI

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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

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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

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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

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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, however

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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

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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)

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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

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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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Partners Capital Account

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

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Partners 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

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Partnership Tax Year

• Profits and losses flow through to partners on
  the last day of the partnerships 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)

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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

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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
• 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, partners basis
  equals the adjusted basis of the property
  contributed

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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
• Partners share of liabilities
• General partner's share in all partnership
  liabilities
• Limited partners share in nonrecourse
  liabilities

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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 by which a cash
  distribution exceeds basis

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General Loss Limitation

• If a partners share of losses exceeds the
  partners 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

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

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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)

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Partners 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

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Nonliquidating Distributions

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

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Liquidating Distributions

• Gain recognized only if cash received exceeds
  partners 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)

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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 (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

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S Corporation Requirements

1. Must be a domestic corporation
2. Have only one class of stock outstanding
3. Have no more than 100 shareholders (family
   members are considered one shareholder)
4. Can have only individuals, estates and certain
   trusts as shareholders
5. 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, 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

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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

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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

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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

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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

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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
• 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

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AAA

• Accumulated adjustment account a corporate
  account that tracks a corporations 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)

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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

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Schedules M-1 and M-2

• Schedule M-1 reconciles book to tax income and is
  similar to C corporations 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)

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

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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

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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
  owners share of qualifying production activities
  income
• Limitation based on 50 of W-2 wages paid is
  determined at entity level

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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

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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

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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
• Materially participated in 5 of preceding 10
  years
• Materially 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 AGIs between 100,000
  and 150,000

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Real PropertyBusiness Exception

• Taxpayer may deduct loss currently if
• Taxpayers spends more than half their time in
  real property businesses in which they materially
  participate and time spent equals or exceeds 750
  hours
• Usually eliminates persons who hold full-time
  positions in other occupations

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The End