Characteristics and Income Taxation of Business Entities

Question 1

Sole Proprietorship

Answer 1

• simplest way of forming a business and signifies that one person entirely owns the business
• the person takes full liability
• The assets and liabilities merge indistinguishably with the owner’s personal assets and liabilities.
• income is reported on the individual tax return on Schedule C
• Can carry NOL’s back 2 years and forward 20 years.
• If there is a loss it is an above the line deduction
• money borrowed for the business is, interest is fully deductible.

Question 2

General Partnership

Answer 2

• a business owned entirely by general partners.
• each partner is fully liable for the debts of the firm, and personal assets of the partners may be taken by creditors to satisfy debts and claims against the firm.
• All income is passed through to the partners, which is divided by their respective ownership.
• Income is reported on a K-1

Question 3

Limited Partnership

Answer 3

• a business owned by both general and limited partners.
• general partners are responsible for managing the business and are considered active owners.
• a written agreement and a state filing are required for the formation.
• income is passed through.
• Limited partners receive passive income according to their share in the business and general partners receive active income

Question 4

Family Limited Partnership

Answer 4

• usually set up by a wealthy sole proprietor in order to obtain benefits of gift, estate, and income tax reduction.
• Owner names themselves as the GP and makes gifts of limited partnership interest to other family members.
• owner is able to make gifts at a discount
• income is distributed to all partners according to their interest

Question 5

Limited Liability Partnership (LLP)

Answer 5

• a general partnership which is managed by its partners and is taxed as a partnership, but the partner’s liability for any professional malpractice of other partners is limited to partnership assets.
• Partners still have unlimited personal liability for the obligations of the firm.
• popular among accountants and lawyers who do not want to incorporate but want protection from personal liability.

Question 6

Limited Liability Company (LLC)

Answer 6

• all members are accorded the protection of limited liability and can participate in management.
• Articles of incorporation are filed with the state and all members must sign an operating agreement.
• can elect to be taxed as a corporation or a partnership. generally taxed as a partnership so that income will flow through to the members.

Question 7

S Corporation

Answer 7

• a corporation that has made an election to have its income, deductions, capital gains and losses, charitable contributions, and credits passed through to its shareholders.
• limited liability for shareholders
• the stockholder vote to elect S status must be unanimous.
• is not subject to corporate AMT or excess accumulations tax.
• cannot have more than 100 shareholders
• the S election may be terminated if more than 25% of its gross receipts for 3 consecutive years are passive investment income.

Question 8

Reasonable Compensation for S Corporation

Answer 8

• Shareholder employees receive W-2 wages as a payment for their services. Additional distributions from corporate profits are not subject to payroll taxes.
• to prevent individuals from paying themselves an unusually low income to avoid paying FICA taxes, if the IRS deems that the W-2 wages are below reasonable compensation the distributions may be re characterized and subject to payroll taxes.

Question 9

C Corporation

Answer 9

• taxpayers in the top marginal income bracket may want to incorporate to take advantage of the lower tax rates on the first $50,000 of corporate taxable income
• A profitable business that retains earnings for growth is still a good candidate for incorporation as a C corp.

Question 10

Factors when considering the reasonableness of employee-shareholder salaries

Answer 10

• amount paid by other employers for similar services
• complexity and difficulty of the job
• employer’s policy with regard to salaries of non-shareholders
• comparison of salaries with other distributions
• whether the amount is based on performance
• $1 MM cap on the salaries of the top 5 officers of a public company.

Question 11

Net Capital Losses

Answer 11

-can be carried forward 5 years and backwards 3 years to offset capital gains

Question 12

Charitable Contributions

Answer 12

• corporations can deduct charitable contributions up to 10% of income each year.
• they can also carry forward any excess contributions up to 5 years.

Question 13

Employee Benefits For Corporations

Answer 13

• health insurance, cafeteria plans, and contributions to retirement plans are deductible for the corporation
• corporations are not subject to passive activity loss rules.

Question 14

Professional Corporation (PC)

Answer 14

• has shareholders who are licensed members of a profession, such as architects, lawyers, accountants, doctors, engineers, or dentists.
• These professionals are always liable for their own errors, omissions, and acts of malpractice, therefor the limited liability function of a corporation is not very important.
• they can take advantage of some employee benefits such as group life insurance and other advantages not available to corporations.

Question 15

Personal Service Corporation (PSC)

Answer 15

• the corporation principally performs services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, or counseling.
• employee-owners perform substantial amounts of the personal services (more than 20%)
• employee-owners own more than 10% of the stock
• they are taxed at a flat rate of 35% on all income (no graduated rates)
• IRS created these in order to prevent individuals from incorporating their business in an attempt to avoid the suspension of passive losses.

Question 16

Personal Holding Company

Answer 16

• A corporation that is owned by a few individuals that makes the majority of its income from investment or passive activities.
• IRC defines it as a corporation where 50% or more of the value of the outstanding stock is owned by 5 or fewer individuals at any time during the year.
• subject to regular income taxes, but must also pay a penalty tax of 20% on any income not distributed to shareholders.
• the tax prevents incorporation of various income producing activities (investing/passive) to accumulate excess earnings or to receive tax benefits.
• constructive receipt test is used to determine who are the owners.

Question 17

Income Test For A Personal Holding Company

Answer 17

• 60% of a PHC’s adjusted gross ordinary income must be PHC income.
• adjusted gross income is gross income less gains on the sale of assets and certain interest income.
• PHC income includes income from dividends, interest, royalties, rents, payments for use of corporate property by 25% or more shareholder, income from a trust, and amounts received from personal-service contracts.
• rents and royalties are excluded from PHC income if one activity exceeds 50% of adjusted gross ordinary income and the other does not exceed 10% of adjusted gross ordinary income.

Question 18

Business Trust

Answer 18

• has trustees who take legal title to the business assets and manage the business for the benefit of the owners.
• they are also called Massachusetts trusts
• often taxed as corporations, rather than trusts.

Question 19

Taxation at Entity and Owner Levels

Answer 19

• All partnerships, S corporations, and LLC’s are flow-through entities. As a result the partners, shareholders, or members report their share of the entity income on their individual income tax returns.
• Dividends are not tax deductible to the corporation that distributes them and are income to the owners of the corporation.

Question 20

Formation of Corporations

Answer 20

• individuals contribute something of value, in exchange for an equity ownership interest (shares of stock) in the corporation.
• assets transferred can be cash, securities, property, business interests, and services.
• if transferring appreciated property, the individual would have to pay a capital gain on the difference between the FMV and their costs basis.
• This can be avoided if the corporation meets 3 requirements:
  1) must be one or more persons making such transfers of property
  2) transfer must be solely in exchange for the corporations stock
  3) Transferors must be in control of the corporation immediately after the transaction

Question 21

Formation of Partnerships

Answer 21

• when a partnership is formed by partners contributing assets to the partnership in return for an interest in it, the transfer is generally tax free. The partners would then have basis in the partnership equal to the basis in the assets that were contributed.
• the basis is adjusted (down) for liabilities assumed by the partners (44.17)
• services contributed in return for partnership share is taxable to the partner at ordinary income. The basis is then increased by this ordinary income.

Question 22

Flow-Through of Income and Losses to Shareholders

Answer 22

• Sole Proprietorships, S corporations, and partnerships pass through income and losses to their owners.
• Limited Liability Companies, Family limited partnerships, and limited liability partnerships are all treated like partnerships for federal tax purposes.
• items of income and loss retain their characteristics as they are passed through to investors.
• passive activity losses, capital gains and losses, section 179 depreciation, tax credits and interest must be separately stated by a partnership or S corporation and must be treated separately by the business owners.

Question 23

Partnership Allocation of Income and Loss

Answer 23

• partnerships are more flexible in determining the allocation of items of income and loss than S corporations.
• S corporations must allocate all items based on stock ownership
• Partnerships may agree to allocate items of income and loss in a variety of ways, as long as the allocations are in keeping with the partnership agreement and have “substantial economic benefit”
• while partnerships and S corporations do not pay taxes, they must file informational tax returns.

Question 24

Pass-Through of Income

Answer 24

• owners receive income as it is earned by the entity, not as it is paid out.
• partnership income from an active business will be subject to self-employment tax to general partners even if it is not distributed, but limited partners generally do not receive self-employment income

Question 25

Use of Losses

Answer 25

• partners and shareholders can deduct losses from pass through entities against income from other sources.
• losses can only be deducted to the extent an owner has basis in his or her ownership share.

Question 26

Accumulated Earnings Tax

Answer 26

• a tax that is levied on corporations who do not distribute accumulated earnings to shareholders. The earnings must not be needed in the reasonable course of business.
• 20% tax on excess accumulated earnings, so corporations have an incentive to distribute income in one form or another.

Question 27

Special Entity Taxes for S Corporations

Answer 27

• Only S Corporations that were formerly C Corporations are subject to the following entity level taxes:
  1) built in gains tax
  2) LIFO Recapture
  3) Excess Net Passive Income Tax

Question 28

Built in Gains Tax (S Corp)

Answer 28

• if a C corp had aggregate assets with a fair market value in excess of basis when it became an S Corp, it would have to pay built in gains
• if in the 5 years after becoming an S corp the corporation sells any of the assets that were at a gain, it will have to pay a 35% tax on those gains.
• This prevents C corps with large amounts of appreciated gains from electing to be an S corp so that the gains from the potential sales are passed through to the shareholders who can reap the benefits of lower capital gains rates.

Question 29

LIFO Recapture (S Corp)

Answer 29

• When a C corp uses LIFO for inventory valuation in its last year prior to becoming an S corp, it must include a LIFO recapture amount in its income for the final year as a C Corp.
• the recapture amount is the difference between the LIFO valuation and FIFO valuation
• the tax is paid in four installments

Question 30

Excess Net Passive Income Tax (S Corp)

Answer 30

• An S corp that continues to have earnings and profits from its time as a C Corp will owe excess net passive income tax if receipts of passive income (from rents, royalties, dividends, and interest) are greater than 25% of its gross receipts.
• the tax is imposed at 35% of the excess net passive income.
• this tax makes an S corp with undistributed C corp earnings a very undesirable entity for holding rental properties or other income-producing assets.

Question 31

Increases and Decreases of Basis

Answer 31

• an owners basis is increased by all items of income allocated to him or her and by any subsequent contributions.
• basis is reduced by items of loss allocated to an owner and by any distributions of money or property.
• A partners basis is increased by his or her share of partnership liabilities.
• An S corps shareholders basis will increase for amounts the shareholder actually loans to the corporation

Question 32

Dissolution of Corporations

Answer 32

-the liquidating dividend is treated as payment in exchange for the stock; thus, it is treated first as a return of capital and then as a capital gain.

Question 33

Taxation of Distributions - Partnerships

Answer 33

• Partnerships and entities treated like partnerships distribute cash or appreciated property to the partners without having the partners or partnership realize income on the transaction.
• the partners basis is in the property is the same as the partnerships basis prior to the distribution.

Question 34

Taxation of Distributions - S Corporations

Answer 34

-must treat any distribution of appreciated property as, first, a sale by the corporation at FMV, and then as a distribution.

Question 35

Taxation of Distributions - C Corporations

Answer 35

• shareholders are first treated as receiving taxable dividends to the extent the C corporation has earnings and profits
• after earnings and profits are gone, further distributions are nontaxable returns of capital to shareholders.
• when shareholders have received an amount equal to their basis in the stock of the corporation, any remaining distribution received is taxable as capital gain.

Question 36

Dissolution of S Corporation

Answer 36

• any gains recognized by the corporation when liquidating appreciated property will pass through to the shareholders.
• shareholders will increase their costs basis and thus reduce the amount of gains that will be taxable upon receipt of the liquidating dividends in return for stock.

Question 37

Complete Redemption

Answer 37

• when the corporation makes a complete redemption of all a shareholders stock in the corporation, tax laws treat it as a sale rather than a dividend.
• after the complete redemption, the former shareholder must have no personal financial interest in the corporation, except as creditor.

Question 38

Substantially disproportionate Redemption

Answer 38

• a redemption will qualify as a purchase or a sale if it is substantially disproportionate.
• after the redemption, the shareholder must hold a percentage of the stock that is less than 80% of the stock held before the redemption
• after the redemption, the shareholder must own less than 50% of the voting stock