Characteristics and Income Taxation of Business Entities Flashcards
Sole proprietorship
- owner is responsible for operating business on day to day basis
- business is undistinguished from owners personal affairs for both legal and tax purposes
Sole proprietorship - advantages
- availability of retirement plan (Keogh, SEP)
- 100% medical insurance premiums deductible by owner
- no legal formalities
- conduit of income or losses to owner (sched. C)
Sole proprietorship - disadvantages
- unlimited liability
- business dies with owner
- capital structure depends on the owners personal resources
Partnerships (general partnerships)
- an association of two or more owners to operate the business for profits
Partnerships - advantages
- availability of retirement plan (keogh, SEP)
- 100% medical insurance premiums deductible by partners
- partnership agreement can be oral
- conduit of income or losses to owner
Partnerships - disadvantages
- unlimited personal liability for acts of the partnership or partner acting on behalf of the partnership (joint and several liability)
- partnerships dissolve upon death, bankruptcy, or incapacity of partner
- capital structure depends on resources of partners
Limited liability company (LLC)
- can be classified for tax purposes as partnership or corporation
- partnership if no more than two of the following
- centralization of management - continuity of life - limited liability - free transferability of interests
- can operate like general partnership (members can be involved in daily operations without losing limited liability status)
- every member has limited liability for all debts or claims against business
Qualified business income (QBI)
- net income (profit) from a pass through business
- includes rental income, publicly traded partnerships and REITS
- can deduct up to 20% of QBI from each business and carry forward loss
2 classes of pass through businesses
- providing personal services: law firms, medical practices, consulting firms, entertainers and athletes
- all other
3 tiers of business owners (based on taxable income)
Tier 1
- single, making less than 182,100 or joint making less than 364,200 for total taxable income may claim full 20% deduction
- doesn’t matter if personal service firm
Tier 2
- single, with more than 232,100, or couples over 464,200 are allowed no deduction if business is personal service firm
- could get limited deduction if they have a different business
Tier 3
- those with incomes between thresholds are eligible for partial benefit
- doesnt matter nature of business
- amount phases out for personal service business
Limited liability partnership (LLP)
- partnership which general partners are not personally liable for malpractice-related claims from misconduct of another general partner
- useful if want to convert from partnership where one or more partners have unlimited liability
- some states allow partnership to convert to LLP
- LLC flexibility preferable to LLP
Regular C corporation
- separate tax entity
- if distributing after tax earnings to owners the distributed income is taxed a second time at the owner level
- 21% flat rate tax
Regular C corporation - advantages
- separate tax entity
- sale of stock to unlimited investors
- dividend received deduction (50% rule)
- limited liability
- continuity of life
Regular C corporation - disadvantages
- corporate formalities
- dividends paid after tax
- accumulated earnings beyond certain limits are subject to double taxation
Dividend received deduction
- US corp investing in another US corp receives a deduction for dividends received
- 50% of dividends received from qualifying corp may be excluded from income if recipient corp owns 20% or less of distributing corp
- 65% exclusions if ownership between 20% and 80%
- 100% exclusion if ownership greater than 80%
Section 1244 qualified small business stock
- S or C corp that was initially capitalized with no more than 1 M
- loss of 100k / yr on a joint return (50K otherwise) is considered to be an ordinary rather than capital loss
Personal service corporation (PSC)
- closely held C corp that is owned by certain individuals can be considered PSC
- any income retained by PSC is taxed at a flat 21%
- businesses classifying as PSC
H: health (doctors, dentists)
A: accounting, architectural, actors
L: law
E: engineering
Subchapter S corporation
- elects special tax treatment and acts as conduit for items of income, deductions, and tax credits
- corp becomes S corp by unanimous election of its shareholders
- S corp status immediately terminated if corporation loses its eligibility
- files taxes on form 1120 S
S corporation - eligibility
- number of shareholders limited to 100
- can only issue single class of outstanding common stock (can be voting/ nonvoting)
- must be domestic corporation
- only individuals, estates, and certain trusts may be shareholders
S corporation - advantages
- limited liability
- conduit of income or loss to owner but limited losses up to basis
- basis = cash + direct loans made by shareholder to corporation
S corporation - disadvantages
- corporate formalities
- sale of stock limited by eligibility standards
Limited partnerships
- any business can operate as this
- need at least one general partner
- liable for partnership debt only to extent of the capital contributions
- role is restricted to passive investor
- if actively participates, they forfeit limited liability
Formation of business taxation
- at formation entity can be tax neutral
- participants can transfer assets to either partnership or corporation in exchange for ownership interest in the entity without recognition of gain
Conduit entities - sole proprietorship
- income or loss reported on sched. C
- if loss, sched C loss carried to first page of 1040
- can carry forward loss indefinitely like NOL
- if owner borrows money for business and pays interest, that debt is deductible on sched. C
Conduit entities - partnerships
- partnership files 1065 for information purposes only
- each partner includes K-1 to report distributive share income or loss
- losses deductible up to basis
- basis is cash and loans made to partnership by partner or by someone else
Conduit entities - S corportations
- losses deductible up to basis
- bank loans not included in basis
- when corp incurs debt, shareholders dont have personal liability for it
- basis is cash and loans made by shareholder to S corp
Conduit entities - LLC
- regardless of number of members, if entity is treated as partnership, only information return is filed
- income subject to tax will pass through to members
- basis same as partnership
- if entitiy makes corporate election, business itself is taxable and files 1120
Risk free entity vs risky entity
risk free
- sole proprietorship
- partnership
risky
- S corp
- LLC
-limited partnership
Corporate accumulated earnings tax
- unless exempt a corp that accumulates earnings and profits to avoid income tax to shareholders is subject to annual accumulated earnings penalty tax equal to 20%
- in addition to regualr corporate tax
- can generally accumulate 250k without establishing need
- need bona fide business need to keep over 250k
Distributions
- corporate stockholders may receive return on investment as dividend
- corp cannot deduct dividend that is distributed
- double taxation
- conduit entities avoid double taxation (S corp, LLC, sole pro)
Summary of tax forms
Corporation
- filing: 1120
- EE: W-2
- distributions: 1099
Self employed
- filing: Sched. C
- EE: Sched. C
- distributions: N/A
Partnership
- filing: 1065
- EE: W-2
- distributions: K-1
S Corporation
- filing: 1120S
- EE: W-2
- distributions: K-1
