Income Tax: Entities Flashcards
1
Q
Under what law are entities formed under?
A
Entities are formed under state law, the state itself dictates the requirements for formation and the formalities that must be followed to maintain the entitiys legal status.
2
Q
What entities do not have Limited Liability Protection?
A
Properietorships, General partners of a limited partnership, general partnerships.
3
Q
What is “piercing the veil” of liability protection and how do you avoid it?
A
Owner loses liability protection for limited liability entities.
to avoid it:
Keep business and personal books and records separate.
keep personal and business affairs separate.
follow corporate formalities such as meeting requirements and filings.
maintain a reasonable amount of liability insurance protection to protect the public.
4
Q
What are the key features of Sole Proprietorships?
A
- Business owned and operated by a single individual
- no annual filings or with the secretary of state.
- proprietor has 100% interest in the proprietorship assets and income.
- Capital is limited to resources of proprietor or what they can borrow
- Proprietor personally legally liable for the debts and torts of the business.
- Proprietor pays self employment tax on his own earnings and half of social security taxes for employees.
- can deduct all ordinary and necessary business expenses on schedule C.
- net income/expenses reported on schedule c.
5
Q
How do you calculate a self employed persons contribution to their Keogh plan?
A
6
Q
What is the maximum contribution a self employed individual can contribute to a keogh plan?
A
25% of the self employed’s earned income.
7
Q
What are the advantages and disadvantages of a sole proprietorship?
A
Advantages:
- Easy to form
- simple to operate
- easy to sell business assets
- few administrative burdens
- income is generally passed through the owner on schedule c of form 1040.
Disadvantages:
-generally have limited sources of capital
-unlimited liability
-no guarantee of continuity beyond the proprietor
business income subject to self employment income
8
Q
What are the key features of a general partnership?
A
- Partnerships automatically created when two or more individuals conduct business for a profit.
- each general partner can participate fully in management and act with full authority for the firm.
- partnership agreements often require the approval of non-selling partners before a partners share can be sold to an outside party.
- Partners vote on disolution. If disolved, they pay creditors and distribute respective share of assets to each partner.
- No liability protection, each partner is joint and severally liable for partnership liability. (major disadvantage
- no requirement for annual meetings and relaxed rules.
- partners can participate in company retirement plans, they have the same limitation as proprietorships.
9
Q
How are general partnerships taxed?
A
- Income and losses are passed through to each partner in proportion of their interest on schedule k-1.
- partners income is subject to self employment tax at 15.3%.
- can deduct all ordinary and necessary business expenses from their income.
- Passive partners, may not be able to deduct losses due to passive activity rules, even if they are at-risk.
10
Q
What are the tax rules for the formation of a partnership?
A
- When a partner contributes cash or property to the partnership, no gain or loss is recognized and the partners basis in the partnership is equal to the value of the cash contributed or the adjusted basis of property contributed.
- if partner contributes personal or professional services to the partnership, the partner must recognize ordinary compensation income for the value of the services. Amount of income recognized becomes partners basis in partnership interest
11
Q
What are the tax ramification of the operation of a partnership?
A
- Partnership must file form 1065, each partner receives Form 1065 K-1.
- Partners adjusted basis is increased each year by his share of income and decreased by his share of partnership losses, non deductible expenses, and distributions.
- if you are a general partner, your partnership earnings are subject to self-employment tax.
12
Q
what are the tax ramifications of withdrawals or distributions from a partnership?
A
- partners may withdraw cash or property from the partnership to meet their needs or as advance payments of their share of partnership income.
- A withdrawal is treated as return of capital and is not taxable. it also does reduce the partners adjusted basis of the partnership.
- once the partners basis has been reduced to zero, any additional withdrawals taken from the partnership will result in a capital gain to the partner.
13
Q
What are the advantages and disadvantages of a partnership?
A
Advantages:
- more initial capital than proprietorships
- usually have more management resources than a proprietorship
- have fewer administrative burdens than corporations
- income and losses are passed through to the partners for tax purposes
Disadvantages:
- transfer of interest is more difficult than proprietorships.
- unlimited liability - each partner is liable for partnership debts and obligations.
- partnership income tax and basis adjustment rules can be complex.
- business net income is subject to self employment tax.
- partners are entitled to few tax free fringe benefits that are available to employees.
14
Q
What are the key features for a limited partnership?
A
- two or more persons as co-owners to carry on a business for profit, at least one general partner and limited partners.
- Formed with a partnership agreement, annual filings required.
- Limited Liability may make it difficult to obtain financing, third party lenders may want personal guarantees form limited liability partners as due to the business setup they cannot access their personal assets.
- Liability for limited partners limited as long as they refrain from participation. General partners who are responsible for the day-to-day operations in a limited partnership have unlimited liability for enterprise debts and obligations.
- limited partners are not subject to self employment tax, general partners are.
- Files a form 1065 and issues K-1’s to both its general and limited partners.
15
Q
Advantages and disadvantages of a limited partnership?
A
Advantages:
- favorable pass-through partnership taxation status
- flexibility in structuring ownership interests
- limited partners are not personally liable for the debts and obligations of the limited partnership as long as they do not engage in management.
Disadvantages:
- must file with the state to register.
- in most states, general partners are liable for debts and other obligations of the limited partnership
- losses for limited partners are generally passive losses.
16
Q
What are the key features of a limited liability partnership (LLP)?
A
- Hybrid entity, partners may enjoy liability protection from the acts of their other partners, but each partner remains personally liable for his own acts with respect to malpractice. (Doctors, Attorneys, Accountants, etc…)
- Required to file with the domiciliary state to establish the limited liability partnership, annual filings required.
- dissolution the same as for general partnerships. if it is for licensed professionals, interest can only be transferred to another similarly licensed professional.
- amount of capital contributed determines the ownership interest for a partner.
- General partners of an LLP are not personally liable for the debts and obligation arising from errors, omissions, negligence, incompetence, or acts committed by another partner.
- LLP is a flow through entity, partners receive a k-1 for their share of business income or losses.
17
Q
What are the advantages and Disadvantages of a LLP?
A
Advantages:
- Favorable pass-through partnership taxation
- flexibility in structuring ownership interest
- partners can insulate themselves from the acts of other partners.
Disadvantages:
- Required to file with the state to register.
- unlimited liability for own acts of malpractice.
18
Q
What are the key features of a Family Limited Partnership (FLP)?
A
- One or more family members transfer highly appreciated property that is expected to continue to appreciate to a FLP in return for a small 1% general partner ownership and a large limited partnership interest.
- No income or gift tax upon creation or funding of the partnership. Original owner is still the owner of the interest.
- limited partnership interests are usually valued at a discount to their FMV. discount can be between 20 % & 40% for the purpose of calculating gift taxes payable by the transferor.
- Original Transferor does annual gifting utilizing the discounts, gift tax exclusions, and gift splitting to transfer limited partnership interests to younger generation family members at reduced transfer costs.
- original transferor/owner can maintain control of the property transferred, even while only retaining a small general partnership interest. (Example Business Transferred: Can still fully manage business and make all decisions with 1% GP interest.)
- Limited partners are protected from creditors also protects limited partners who are married from spouse taking assets in the event of a divorce.
19
Q
How are Family Limited Partnerships taxed?
A
- A FLP is taxed as a partnership, entity files a form 1065 and issues k-1’s to both general and limited partners.
- FLP should have its own checking accounts, TIN, and payroll.
- FLP should not allow family members to withdraw funds at will, nor should the FLP pay for the personal expenses of its owners.
20
Q
What are the advantages and disadvantages of a FLP?
A
Advantages:
- Control retained by senior family member
- valuation discounts are available for minority interests
- annual exclusion gifts are general used to transfer interest to family members
- some creditor protection
- restrictions can be placed on transferability of limtied partnership interest of junior family members.
- FLP Is commonly used as an estate planning strategy.
Disadvantages:
- Attorney setup fees and costs
- periodic valuation costs
- operational requirements
- potential IRS challenges regarding valuation and discounts.
21
Q
What are the key features of Limited Liability Companies (LLC’s)?
A
- Formed in the same way as corporations. They are chartered entities registered with the secretary of state in the state of organization.
- Generally owners contributions determine the ownership percentage of an LLC. Disposal or transferability of interest are clarified in the operating agreement.
- LLC’s individual owners are protected from the personal liability for the LLC’s debts and obligations. “piercing the veil” can cause can give the courts the power to disregard the Liability protection.
- LLC is managed by virtue of an operation agreement. The agreement dictates what is going to happen with regards to management of the LLC.
- An LLC is not required to have an operating agreement, if there is no operating agreement it is governed by the state laws regarding LLC’s. Operating agreements are better because it makes sure everyone is happy.
22
Q
How are LLC’s taxed?
A
-If owner is a single member/owner:
The owner must filed schedule C of Form 1040 for LLC, same as sole proprietorship. Pays self employment tax and half of employees.
-LLC with two or more members:
Can elect to be taxed for federal income tax purposes as a partnership (Form 1065 & K-1s), S Corporation (Form 1120s & K-1s), or a C Corporation (Form 1120 with W-2 income to the owners)
- As a pass Through entity, LLC is taxed to members at their personal rates. Losses are deductible on personal income tax returns to the extent of basis, may be limited by the passive activity rules.
- no gain or loss on distribution of appreciated property to LLC member. Gain will be recognized to the extent cash received exceeds members basis.
- Income earned by members is normally subject to self employment tax on the tax returns of individual tax members. There are two exceptions:
- LLC income derived from rental real estate.
- LLC members who are not the managing member and are the equivalent of limited partners.
-income tax consequences applicable to the formation of an LLC are identical to those of a partnership.
23
Q
What are the advantages and disadvantages of an LLC?
A
Advantages:
- Members have limited Liability.
- Number of Members is unlimited but a single member LLC is disregarded entity for tax purposes.
- members may be individuals, corporations, trust, other LLCS, and other entities
- income passed through to members, Schedule k-1
- Double taxation affecting most C corporations is avoided if partnership tax status is elected.
- members can participate in managing the LLC.
- Distributions do not have to be proportionate to ownership interest like S-Corps.
- Can have multiple classes of ownership
- entity may elect to be taxed as a partnership, S Corp, or a C Corp.
Disadvantages:
- May have limited life
- transfer of interest is difficult and sometimes limited by operating agreement.
- some industries or professions may not be permitted to use LLC status.
- laws vary from state to state regarding LLCs
- Laws are relatively new for LLCS, therefore, precedent from prior court cases are limited.
- for tax purposes the complex partnership rules generally apply
- members not meeting exceptions are subject to self employment tax on all earned income if partnership status is elected.
24
Q
What are the key features of C Corporations?
A
- Corporations are formed by filing a charter document with the state of incorporation called the articles of incorporation.
- Ownership in a corporation are held by a shareholder and are evidenced by shares of stock certificate. Shares may be all one class or several classes. Different classes of stock have different values/voting rights.
- Corporations can raise capital more easily through stock than sole proprietorhips or partnerships.
- Liability in corporations is limited to invested capital. Individual shareholders of the corporation have limited liability, as long as the corporation does not pierce the veil.
- corporations are managed by one or more officers appointed by the board of directors. The board of directors is the governing body of the corporation. The board of directors appoint various officers to run the corporation (president, chief financial officer, secretary, treasury).
- corporations are required to observe corporate formalities and maintain good standing with the secretary of state, in the state of incorporation.
25
How are C Corporations Taxed?
- C Corporations file a Form 1120 and pay taxes on their own income on a calendar or fiscal year basis.
- owners/employees do not pay self employment tax and only have to pay half of SSN tax.
- Distributions of cash and other assets to a shareholder/employee in his capacity as a shareholder rather than an employee is considered to be dividends.
- Shareholders must include the dividends in gross income, therefore the income of a C-Corp is taxed twice. Once at the corporation level and a second time at the shareholder level.
- When appreciated property is sold and distributed to Shareholders, gain is recognized at the corporate level. For an S-Corp the gain is passed through to shareholders and taxed on their individual income tax returns based on their ownership interest.
- Corporations are taxed at a flat rate of 21%.
- If a corporation incurs a net operating loss, the loss can be carried forward indefinitely if not fully used.
26
How are Dividends Treated for Corporations?
- Dividends from a corporation are deductible to the shareholder, depending on their ownership percentage.
* See the image for the table.
27
What is a personal service corporation (PSC) and how is it taxed?
- A C Corporation in which substantially all of the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, and substantially all of the stocked is owned by employees.
- These are taxed at a flat 35%.
28
What are the advantages and disadvantages of a C Corporation?
Advantages:
- Ease of raising capital.
- limited liability of shareholders
- unlimited life of entity
- ease of transfer of ownership interest
- generally more management resources
- shareholder/employees may receive full array of employer-provided tax free fringe benefits.
Disadvantages:
- potential for double taxation due to entity level taxation
- administrative burdens
- more difficult to form and dissolution can cause taxable gains.
- borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability.
- requires a registered agent.
- requires a federal tax ID number.
29
What are the key features of a S-Corporation?
- Normally created under state law by first forming a C Corporation and then filing an "s" election with the IRS.
- like a C Corporation, ownership interest in a S Corporation are held by shareholders and are evidenced by shares of stock.
- Raising capital is tougher than a C Corporation because you can only have 100 shareholders.
- shareholders liability is limited to the shareholders capital contributions.
- managed by one or more officers appointed by the board of directors.
30
What are the requirements for a corporation to make and keep the "S" Corp. election?
- Must have less than 100 eligible shareholders.
- restricted to individuals who are US Citizens or US Residents, certain trust, and charitable organizations.
- The corporation must be an eligible corporation created under the laws of the united states or any state.
The corporation is allowed only class of outstanding stock, that one class may have shares with voting rights and shares with no voting rights.
31
How are S Corporations taxed?
- Income from S Corp is passed through to shareholders and is not taxed at the corporation level.
- income not subject to self employment tax, but employees/owners pay 1/2 of SSN tax. Anything beyond their reasonable compensation is considered dividends not subject to payroll tax.
- if appreciated assets are sold and distributed to shareholders. They will pay capital gain to all shareholders in proportion of their ownership even if the asset was only distributed to one shareholder.
- computation of a shareholders basis in a S Corporation stock is similar to that for partners in a partnership.
- Distributions from S Corporations are considered non taxable (return of capital) to the extent of shareholders basis. Any distribution in excess of stock adjusted tax basis is treated as a capital gain.
- shareholders taxable basis in the stock must be adjusted each year to reflect the allocated items of income and expense. Basis is increased by a shareholders distributive share of both taxable and non taxable corporation income and is decreased by the shareholders share of S Corporation Losses, nondeductible expenses and distribuitions.
32
What are the advantages and disadvantages of S Corporations?
Advantages:
- Income is passed through to shareholders
- income is taxed at the individual level this may be lower tax rate than the applicable corporate rate.
- shareholders have limited liability
- distributions from S Corporations are exempt from the payroll tax system, assuming the corporation provides adequate compensation to those shareholders who are employees of the corporation
Disadvantages:
- limited to 100 shareholders
- only one class of stock is permitted
- cannot have corporate, partnership, certain trust, or non resident alien shareholders.
- shareholder employees owning more than two percent of the company must pay taxes on a range of employee fringe benefits that would be tax free to a shareholder/employee of a C Corporation.
- the tax rate of the individual shareholder may be higher than the corporate tax rate.
- borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability.
33
What Is a Personal Holding Company?
A corporation is a personal holding company if both of the following requirements are met:
1. Personal Holding Company Income test. At least 60% of the corporations adjusted ordinary gross income for the tax year is form dividends, interest, rent, and royalties.
2. stock ownership requirement. At any time during the last half of the tax year, more than 50% in value of the corporations outstanding stock is owned, directly or indirectly, by 5 or fewer individuals.
34
Entity selection chart: part 1
35
What is the 20% Qualified Business Income Deduction?
- for 2018-2025, taxpayers can deduct 20% of qualified business income from a partnership, S corporation, or sole prop.,
- as well as 20% of aggregate qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income.
- A limitation based on w-2 wages paid is phased in for married filing jointly taxpayers with income of $340,100 or more ($170,500 for individuals) in 2022.
36
Entity selection chart: part 2
