Sole Proprietorships and Flow-Through Entities

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Sole ProprietorshipsandFlow-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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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 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 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 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 default
• Nonrecourse 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 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
  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 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 partners basis
• Reduce for cash received then for basis of
  property received (partner takes partnerships
  basis for property)
• If cash distribution exceeds partners 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 corporations 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 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 dont 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