Key Terms End of Each Chapter Flashcards
LLC (Limited Liability Company) - L1C1
limited liability & pass through tax treatment income & losses to investors
Unlimited # of persons may invest & have limited liability, & company does not need to have any person retain unlimited liability
LLCs now authorized by law in all 50 states and District of Columbia
Closely Held Business - L1C1
owned by limited # of SHs, who are usually also the primary employees
A CHB is incorporated according to state law, but its shares are not traded, & it operates like a partnership in many ways
Limited Partnership - L1C1
composed of active, or general, partners & passive investment, or limited, partners
GPs have personal responsibility for business operations & unlimited legal liability
LPs only at risk for up to the amount of their investments
Even when additional interests are sold to limited partners to raise capital, the control held by the GPs is not diluted
LLP (Limited Liability Partnership) - L1C1
registers w/ the state so all partners protected by limited liability
All partners may be GPs & still have limited liability
LLP differs from a limited partnership because w/ the latter entity, GPs not protected by limited liability & at least one GP is required
Pass-Through Taxation - L1C1
concept in federal income taxation that business entities, except for corporations, do not pay income tax on their income; rather, the income will be reported by the business owners on their individual income tax returns. As a result, the income will avoid double taxation
Medicare Contribution Tax - L1C1
comprised of:
- 0.9% Medicare tax on earned income
- 3.8% tax on net investment income (NII)
Both taxes imposed on modified adjusted gross income (MAGI) over $200K for individuals and over $250K for married filing jointly
The 3.8% tax is imposed on the lesser of (1) the taxpayer’s NII or (2) MAGI in excess of the threshold amount
NII (Net Investment Income) - L1C1
subject to 3.8% Medicare Contribution tax for individuals w/ modified adjusted income over $200K & for married filing jointly over $250K
NII defined to include interest, dividends, payments from NQ annuities, royalties, rents, & capital gains from assets not held in a trade or business
Pass-Through Entity - L1C1
Partnerships & S Corps are said to be pass-through entities
The earnings of these companies are not taxed to the company but to the owners
earnings are passed through to the owners & then taxed @ the owners’ individual tax rates
Termination by Operation of Law - L1C1
occurs in a general partnership upon death of one of the partners
surviving partners forced to liquidate business & distribute the assets according to the relative partnership interests or the surviving partners will sell the assets & distribute the cash
The decedent’s estate must be paid for its ownership interest
Key Employee - L1C1
an employee who possesses unique skills, knowledge, or business contacts, & whose loss would be devastating to the company
The death/disability of a key employee results in loss of income for the corp
the employee’s unique skills, experience, or talent may not be easily replaced @ the same salary level
Another significant contribution which may be from a key employee is a large client following or a large source of capital or credit to the company
Compensation Planning - L1C1
Purpose is to create a compensation package that best meets the needs of the owners & the business
Planning must take into consideration the sources of income for the business, any tax costs, & ways to minimize the costs of the compensation package
Guaranteed Payments - L1C1
When fixed payments are received by a service partner in an organization, the payments are not called a salary, but guaranteed payments
A service partner is one who provides important skills or services to the partnership
Real Property - L1C1
land & anything permanently attached to the land
Personal Property - L1C1
any property that is not attached to land & generally is moveable
Consequential Losses - L1C1
indirect loss, resulting from a direct loss, which decreases the net income of a business
Such a loss would occur if gross receipts were reduced through the curtailment of operations or if operating expenses were increased
Ex. a fire causes a direct loss by destroying a hotel; consequential losses to the hotel follow as a result of losing the revenues from room rentals
Articles of Incorporation - L1C2
Prepared by organizers of a corp, set forth pertinent facts about the corp, including its purpose, capitalization, # of directors, name, & location; the powers of the directors & the manner of their election; & any other information required by the state
Articles of Incorporation are filed w/ the state, along w/ the filing fees & any taxes
If the articles comply w/ the statues, a certificate of incorporation is issued by the state
Bylaws - L1C2
corporate bylaws = state the duties & powers of the corporation’s BOD &SHs
bylaws provide rules for director & SH meetings & for other matters pertaining to corporate operations
bylaws are adopted either by the directors or the incorporators, depending on state practice
Quorum - L1C2
minimum # of directors (typically a majority) which must be present for the BOD to take any action
Business-Judgement Rule - L1C2
Corporate officers & directors must meet their fiduciary obligations to the corp, which is measured by a standard known as the business-judgement rule
This rule holds that if officers and directors use honest, acceptable business judgment, they will avoid liability for corporate losses
Cumulative Voting - L1C2
voting method designed to insure representation of minority stockholders on BOD
some states require cumulative voting, while other states permit it if authorized by the corporate charter
each share of stock receives one vote for each of the directors to be elected at a meeting
The SHs may accumulate votes and allocate all votes for one candidate or spread the votes among the condidates
Formula to determine the # of votes necessary to elect a given # of directors:
S = ((TxN) / (-D+1)) + 1
S = # of shares needed to elect N directors T = Total # of shares voted N = # of directors the SH hopes to elect D = Total # of director positions to be filled
Voting Trust - L1C2
Arrangement whereby SHs transfer shares in a corp to a trust
the trustee then can exercise voting rights represented by the shares allowing stockholders to combine their votes to realize common objectives, as long as those objectives are proper
The stockholders receive trust certificates for their shares & retain their beneficial interest in the stock such as receipt of dividends
Professional Corporation - L1C2
corp whose owners must be licensed members of the profession
Owned by SHs who perform professional services & who operate their corporation according to state laws, just as any other corp
Proprietorship - L1C2
business enterprise owned by one person
the owner usually manages the business but may hire employees & agents to assist in the operations
Partnership - L1C2
Unincorporated association of two or more persons carrying on as voluntary co-owners in a business for profit
General Partnership - L1C2
business entity composed only of GPs, each of whom is a general agent for the firm & is fully liable for the debts & other obligations of the firm
Tenants in Partnership - L1C2
refers to the legal relationship of general partners to the partnership’s property
The partners own partnership property as tenants in partnership
Each partner has equal right to possession of partnership property (but they may exercise that right only for partnership purposes)
Partnership Interest - L1C2
Each general partner owns a partnership interest composed of their share of the firm’s profits & surplus
surplus = total value of firm’s assets minus liabilities
partnership interest is intangible personal property & will be so treated for state inheritance tax purposes
Assignee in Interest - L1C2
party that receives an interest in a partnership but does not become a partner
ex a third party buyer, the estate of a deceased partner, or someone who gets a partnership interest as a gift
Dissolution - L1C2
the result of any change in the relationship among partners that results from any partner ceasing to be associated in the carrying on of the firm’s business
Members - L1C2
A member of a limited-liability company is an owner
No limit on the # of members in an LLC, but there must be at least two
Operating Agreement - L1C2
An operating agreement for a limited-liability company states the rules under which the organization will conduct it’s business
The agreement specifies how the company will be managed, how profits will be divided, & how the members will conduct business
QBI (Qualified Business Income) - L2C3 ** PULLED FROM INVESTOPEDIA
net business income, not including capital gains & losses, certain dividends, or interest income
eligible for 20% tax deduction for QBI, business must be pass through entity (SP, partnerships, S Corps, trusts and estates
C corps income is subject to corporate tax rates
20% deduction reduces federal & state income taxes but not social security or medicare taxes, which means it also doesn’t reduce self employment taxes
Accumulated Taxable Income - L2C3
Accumulated-earnings tax is a penalty tax designed to prevent the avoidance of taxes by accumulating of earnings w/in a corp beyond the expected needs of the business
Accumulated taxable income is defined as the taxable income of the corp less:
(a) corporate taxes paid on income
(b) dividends paid
(c) amounts accumulated as retained earnings for reasonable business needs or, if greater the remaining minimum accumulated earnings credit
PSC (Personal Service Corporation) - L2C3
Engaged substantially in performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, & substantially all stock is held by employees performing the services, by retired employees, or by their estates
A business receiving most of its income in commissions is NOT a PSC
Grantor Trust - L2C3
Under the income tax laws, a grantor trust = a trust over which the grantor has retained certain powers/benefits, so the income is taxed to the grantor rather than to beneficiaries or to the trust
Typically, the grantor trust is a revocable trust, & the grantor places assets in the trust w/ the aim of having them avoid probate
QSST (Qualified Subchapter S Trust) - L2C3
Law allows formation of a qualified Subchapter S trust (QSST) to hold S Corp stock
Useful planning device for splitting S Corp income among family members, w/out relinquishing complete control of the stock
The tax burden is thereby shifted to the trust beneficiary, but the trustee votes the stock until the designated trust termination date
ESBT (Family Partnership electing small business trust - L2C3
Family Partnership = partnership consisting of family members who are treated as partners, regardless of whether they are actively involved in the partnership or have made any contribution to it
ESBT = special trust eligible to hold S Corp stock, may have more than 1 SH, but the trust may only receive the S Corp stock by gift or bequest
Estates & individuals may be beneficiaries, & qualified charities may be contingent beneficiaries
While the EBST has the advantage of allowing more than one current beneficiary, it has the disadvantage that income is taxed to the trust at the highest individual income tax rates, currently 35% & capital gain at the rates for individuals
QSSS (Qualified Subchapter S Subsidiary) - L2C3
Wholly owned subsidiary of a Subchapter S Corp
If a QSSS election is made, all income, deductions, & credits are treated as belonging to the S Corp which is the parent company
Self Employed Business Owner - L3C4
for federal income tax purposes include SP, partners, & owners of S Corps (more than 2% owners)
Cannot participate in favorable tax treatment of employer-provided health & accident plans
Self employed persons are able to obtain retirement plan benefits similar to what is provided by corporate retirement plans
Reasonable Compensation - L3C4
Under Sec 162, only reasonable compensation qualifies as a business deduction
Purpose is to distinguish b/t bona fide compensation pmts & disguised dividend distributions
Reasonable compensation taxed only once to employee
Excessive compensation pmts deemed to be distributions, thus taxed twice, once at corporate level & once to employee-SH
Reasonableness standard is imprecise, IRS can attack pmts of closely held corps
Lack of precision means an opportunity for planning & tax strategy
Important Point: compensation will have to be defended, the best defense is properly documented authorization of compensation that is related to the employee’s contribution to the business
Zero Tax Bonus Plan - L3C4
bonus amount paid to employee after deduction of income taxes
Since bonuses are taxable, employees are liable for additional income taxes
In order to offset the additional taxes it is possible to determine the required bonus that will deliver the desired net bonus to the employee:
Formula:
Required Bonus = TB / (1 - t)
TB = after tax bonus to be paid t = employee's tax bracket
Salary Reduction Plans - L3C4
Permit executives to postpone to future years current earnings as long as the constructive receipt & economic benefit tax doctrines are not violated
Plan should exist prior to earning of the compensation (constructive receipt) & the property cannot be protected from the creditors of the business (economic benefit)
SERP (Supplemental Executive Retirement Plan) - L3C4
NQ plans (deferred) that provide for supplementary, compensatory pmts @ retirement or death benefits
Must not violate the constructive receipt & economic benefit rules
Only difference b/t SERPs & excess-benefit plans is the latter are used solely for executives whose qualified deferrals equal the statutory limits
DBO (Death Benefit Only) Plan - L3C4
NQ plans that provide death benefits for the executives’ beneficiaries
Pmts may be in installments or lump sum & are taxable to the beneficiaries when received
NQ plan - must not violate constructive receipt & economic benefit rules
To avoid inclusion in decedent’s estate, all incidents of ownership (such as right to change beneficiaries) MUST be relinquished & decedent must not have been a participant in any other NQ plan providing living benefits
Constructive Receipt - L3C4
concept in tax law which requires the recognition of income when it becomes available to the taxpayer, w/out any significant restrictions or limitations
Income is taxed regardless of whether or not the taxpayer actually receives it
Taxation of income may not be deferred with the following exceptions:
- When an agreement b/t the employer & employee regarding the income deferral is established prior to the compensation being earned
- When the deferred income is a contribution to a qualified profit sharing retirement plan
Economic Benefit - L3C4
Taxable benefit an employee receives from a NQ deferred compensation plan, whether or not the employee is in constructive receipt of the benefit
An economic benefit is a cash equivalency which has been set aside for the employee & is not accessible to the employer’s creditors, such as an employer’s vested contributions to the plan
Sec 79 Plan - L3C4
the cost of group term life insurance up to $50K is excludible from the taxable income of the employee & deductible by the employer as long as all employees are covered (or eligibility is determined by age, marital status, or factors related to employment)
Special eligibility rules for companies w/ fewer than 10 employees
Cost of coverage in excess of $50K is taxable to the employee, based on factors provided by the IRS
Sec 162 Plan - L3C4
Plans that satisfy the reasonableness requirement of the Internal Revenue Code may provide various forms of compensation, including executive bonuses in the form of life insurance
Premiums are deductible by business & must be included in the income of the executive
Advantages of bonuses to fund life insurance:
- Administration is simplified
- Discrimination in favor of key employees is permitted
- These plans can be used to supplement Sec. 79 plans (known as carve-out plans)
- The pmt is tax deductible; this is especially important for the personal-services corp since insurance premiums are not deductible
Split Dollar Plan - L3C4
splitting the benefits of life insurance into its savings & pure insurance & allocating the costs b/t the company & the executive
The executive’s taxable income includes the economic benefit (the pure insurance portion in the traditional plan minus any amount paid by the executive
Premium pmts by the employer are not deductible
DB subject to estate taxation – if includible in executive’s estate, if there were any incidents of ownership w/in 3 years of death, or if the executive was a majority SH and the corp possessed incidents of ownership
Generally exempt from ERISA vesting, funding, participation, claims procedures, & fiduciary appointment requirements
Traditional Form: requires the executive to pay the excess of premium over the increase in cash surrender value; death benefit also split w/ corp receiving the cash surrender value; employee does not possess any living benefits
