Lesson 5 of Income Tax Planning: Entities

Question 1

Introduction!

Answer 1

One of the most important decisions new business owners have to make is?

The most common legal forms of business used in the USA

The selection process includes consideration of the following factors:

Question 2

One of the most important decisions new business owners have to make is?

Answer 2

The selection of the entity type used for conducting business activites of the enterprise.

Question 3

Most Common Forms of Business Entity Types in the USA are:

Answer 3

A Sole Proprietorship

A Partnership

A Limited Liability Partnership (LLP)

A Corporation

A Limited Liability Company (LLC)

Question 4

Selection Process Includes Consideration of the Following Factors

Answer 4

Ease and Cost of Formation

Complexity of Management and Governance

Transferability and Dissolution

Liability Protection for Owners’ Personal Assets

Reporting Requirements and Taxation

Question 5

Ease and Cost of Formation

Answer 5

Entities are almost always formed under state law. The state dictates the requirements for formation and the formalities that must be followed to maintain the entity’s legal status.

Proprietorships and general partnerships are less complex, inexpensive, and easy to form.

While the other entity types are more complex and more expensive to form.

Question 6

Complexity of Management and Governance

Answer 6

The administrative requirements and formalities dictated by state law are the least burdensome for sole proprietorships and become more involved with the other entities.

Requirements can include:
-initial registration with the state,
-annual filing requirements
-state- imposed operational requirements that must be met to assure continuation of the entity’s legal status and the benefits that
the legal status brings.

Question 7

Transferability and Dissolution

Answer 7

Transferability of an ownership interest is easiest with a proprietorship and becomes increasingly more difficult as we move along a spectrum of business entities to the C corporation.

Partnerships, limited partnerships, LLPs, FLPs, LLCs, S corporations, and smaller C corporations generally have limited or restricted transferability rights.

Unlike other business forms, proprietorships can be dissolved at the election of the owner and do not require formal steps for dissolution.

Question 8

Liability Protection for Owners’ Personal Assets

Answer 8

Some business forms offer liability protection for investors. We refer to this protection as limited liability protection.

If liability protection is available, the investors in such business ventures or entities will not have their personal assets exposed to business (entity) debts or obligations.

This protection, which may be the most important factor in entity choice, is not available to proprietorships or general partnerships, nor to general partners of a limited partnership and only to a limited extent for limited
liability partnerships (LLP).

Question 9

What Are the Situations in Which an Entity That Has Limited Liability Protection For Its Owners Under State Law can Lose That Protection?

Answer 9

The state requires that for such protection to continue, the entity must alert the public to its status in a clear and identifiable manner so as to put business creditors on notice that the entity has such protection.

Entities do this through markings on business correspondence such as invoices, letterhead, business cards, and through markings on vehicles (with the name and LLC or Inc. designated), which signals the limited liability status to the public.

Failure to maintain that identity in contracts and correspondence could result in a court “piercing the veil” of liability protection, which could result in personal liability for the owner(s). Piercing the veil means disregarding the legal status of the entity that gives the owners limited liability.

To avoid piercing the veil, the entity should keep its books and records separate from the personal books and records of the owners, segregate activities of business from personal affairs, follow corporate formalities such as meeting requirements and filings, and address all content in contracts and correspondence from the view point of the business entity (rather than the owners’).

The entities should also maintain a reasonable amount of liability insurance to protect the public (e.g., vehicle liability insurance) and are required to be vigilant in meeting any annual formalities to maintain the state-granted entity status.

Question 10

Reporting Requirements and Taxation

Answer 10

States individually require annual filings and other types of reporting.

All entities that have employees have payroll reporting at both the state and federal level.

All entities that have retail sales have sales tax returns to prepare in states that impose sales taxes.

Question 11

Sole Proprietorships

Answer 11

What are Sole Proprietorships?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 12

What Are Sole Proprietorships?

Answer 12

Sole proprictorships are business ventures owned and operated by a single individual.

A sole proprietorship arises when an individual engages in a business for profit.

A sole proprietorship can operate under the name of the owner or it can conduct business under a trade or fictitious name such as “The Corner Pocket.”

No filings are required with the Secretary of State and no annual filing fees are required.

There is no transfer of assets to the entity because the entity is considered a legal extension of the proprietor.
- The Business and the owner are closely related. The assets are treated as belonging to the owner.

Question 13

Formation

Answer 13

Formation is easy and inexpensive, although the proprietorship may be required to obtain a local business license.

If the proprietorship will be collecting sales taxes, it must register with the state or local taxing authority.

Operation is easy in that all decisions are made by the proprietor.

Any trade names or assets are owned by the individual proprietor.

Question 14

Interest, Disposal of Interest, and Dissolution

Answer 14

A proprietor has a 100 percent interest in the proprietorship assets and income.

It is relatively easy to sell assets of a proprietorship, but it does require finding a buyer.

Dissolution is achieved by simply discontinuing business operations and paying creditors or by the death of the proprietor.

Question 15

Capital

Answer 15

Capital for a proprietorship is limited to the resources of the proprietor including the proprietor’s ability to borrow.

Question 16

Liability

Answer 16

One of the major disadvantages of a sole proprietorship is the potential legal liability.

The sole proprietor is personally legally liable for the debts and torts of his sole proprietorship business.

Question 17

Management/Operations

Answer 17

The proprietor has the day-to-day management and decision-making responsibilities, including the hiring and firing of employees. There is no guarantee of continuity beyond the proprietor.

Question 18

Income Taxation and Payroll (Social Security) Taxes

Answer 18

The cost of tax compliance is low because the proprietor simply adds a Schedule C to his Form 1040.

The proprietor conducts business under his own Social Security number unless the proprietor hires employees, in which case an Employer Identification Number (EIN) must be obtained.

A sole proprietor does not have to pay unemployment taxes on himself, but he must pay unemployment taxes for his employees.

The proprietor does pay self-employment tax
(up to 15.3 percent) on his own earnings and one-half of Social Security taxes for his employees.

The proprietor can deduct all ordinary and necessary business expenses from gross income. The business deductions are in Part Il of Schedule C.

The net profit or loss from Schedule C is then carried over to the Form 1040.

The proprietor may also make deductible contributions to a qualified or other retirement plan, but these contributions are reported on his Form 1040 as a deduction for AGI.

Question 19

To Calculate The Self-Emplopyed Individual’s Contribution to the Keogh Plan, Utilize the Following Formulas

Answer 19

The 92.35% of the calculation is designed to make sure flow-through entities get treated similarly to c-corps. A c-corp’s net earning already reflect the deduction taken for the employer portion of FICA taxes.

Social Security wage base for 2023 is $160,200.

Social security tax is 6.2% and Medicare tax is 1.45%

Question 20

Self-Employed Contribution Rate Formula

Answer 20

When solving the Keogh contribution calculation, it is important to understand that while 25 percent of compensation is the limit for deductible employee contributions, the self-employed individual maximum contribution is 25 percent of the self-employed individual’s earned income. The 25 percent of earned income
effectively translates to 20 percent of net self-employed income less one-half of self employment tax.

If a self-employed individual hires an employee, they must contribute equally. If the employee is given 15%, the employer must use 15% in the self-employment calculation: 15% divided by 1+15% = 13% contribution for the employer.

Question 21

Calculate Self-Employment Tax

Answer 21

Note that the “Up to $160,200” means if the “Net Earnings Subject to Self Employment Tax” is more than $160,200 you use $160,200. If less use the Earnings Subject to Self Employment Tax number.

The Plus 2.9% on call income is multiplied by the “Net Earnings Subject to Self Employment Tax.”

Question 22

Calculate The Self Employed Individuals’s Qualified Plan Contribution Formula

Answer 22

Do not forget to half the “Self Employment Tax” you calculated above.

Question 23

Example

Alex has Schedule C net income of $200,000 and wants to know the maximum amount he
can contribute to a Keogh profit sharing plan. In this instance Alex can contribute $37,642 to
the plan. The contribution is calculated as follows:

Answer 23

Question 24

When Solving the Keogh Contribution

Answer 24

When solving the Keogh contribution calculation, it is important to understand that while 25 percent of compensation is the limit for deductible employee contributions, the self-employed individual maximum contribution is 25 percent of the self-employed individual’s earned income. The 25 percent of earned income
effectively translates to 20 percent of net self-employed income less one-half of self employment tax.

If a self-employed individual hires an employee, they must contribute equally. If the employee is given 15%, the employer must use 15% in the self-employment calculation: 15% divided by 1+15% = 13% contribution for the employer.

Question 25

Advantages of Sole Proprietorships

Answer 25

Easy to form

Simple to operate

Easy to sell business assets

Few administrative burdens

Income is generally passed through to the owner on Schedule C of Form 1040

Question 26

Disadvantages of Sole Proprietorships

Answer 26

Generally have limited sources of capital

Unlimited liability

No guarantee of continuity beyond the proprietor

Business income is subject to self-employment tax

Question 27

General Partnerships!

Answer 27

What are General Partnerships?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 28

What are General Partnerships?

Answer 28

Partnerships are joint business ventures among two or more persons or entities to conduct a business as co-owners under their names or under a trade or fictitious name.

A partnership is automatically created when two or more individuals conduct business for a profit.

There are different types of partnerships including general partnerships and limited partnerships.

Typically, general partnerships are not required to be registered with the Secretary of State in the state of formation, but limited partnerships are required to register.

Each general partner is a general agent for the business and can participate fully in management and act with full authority for the firm.

Question 29

Formation

Answer 29

Although partnerships are easy to form, state law will govern the relative rights and obligations of the partners (including equal sharing of profits and losses regardless of contributions of property or effort), unless there is a
contrary agreement among the partners.

Ownership of a general partnership may be in the form of partnership units, shares, or percentages.

Question 30

Interest, Disposal of Interest, and Dissolution

Answer 30

A partner’s interest in a partnership is frequently referred to as his partnership percentage interest.

The partners usually have voting power in proportion to their ownership interest.

It is generally difficult to dispose of a partnership interest because any buyer will not only have to evaluate the business, but also the other partners. In addition, partnership agreements often require the approval of non-selling
partners before a partner’s share can be sold to an outside party.

Partnership dissolution is either voluntary or judicial (ordered by a court). Partners usually vote for voluntary dissolution and, if affirmed, pay creditors and then distribute remaining assets to partners in accordance with either the partnership agreement or in proportion to their individual partnership interests.

Judicial dissolution may be necessary when the partners cannot agree on how to conduct the business or whether to dissolve the entity. This situation is most likely to arise when partnership votes are required to be unanimous.

Question 31

Capital

Answer 31

The amount of capital contributed usually determines the ownership interest of a partner in a partnership.

However, sometimes partners allocate ownership interest differently from capital contributed. Such a situation could occur when one partner brings ideas and talent and the other brings money.

Whenever partners are deviating from ownership based on capital contributed, there should be a written partnership agreement that clarifies partnership interests and each partner’s distributive share of partnership profits and losses.

Question 32

Liability

Answer 32

The co-owner partners share the risks and rewards of the business. Each partner is jointly and severally liable for partnership obligations. Like a sole proprietorship, a partner’s personal assets can be seized to satisfy partnership
obligations.

A principal disadvantage of the general partnership arrangement is that all general partners in a partnership are subject to joint and several liability for the debts and obligations of the partnership.

Question 33

Management/Operations

Answer 33

Partnerships are generally managed equally by all partners. It is possible to name a “managing partner” to have responsibilities for some specific task or day-to-day operations.

Partnerships can even appoint presidents and
vice presidents as officers. If so, these should be spelled out in the written partnership agreement.

Partnerships are not required to have annual meetings of partners, but rather have a relatively relaxed set of rules regarding formalities.

Employees of general partnerships are eligible to receive a wide variety of tax-free fringe benefits provided by the employer such as health care. This is not so for partners since partners are not considered to be employees for most employee fringe benefit purposes.

However, partners can participate in company-sponsored retirement plans, but they have the same limitations as proprietors in terms of calculations (see discussion under
proprietorships).

Question 34

Income Taxation and Payroll (Social Security) Taxation

Answer 34

General Taxation

Tax Ramifications of Formation of a Partnership

Tax Ramification of Business Operation of a Partnership

Tax Ramification of Withdrawals or Distributions from a Partnership

Question 35

General Taxation

Answer 35

Partnerships are not subject to entity level taxation.
-In partnerships, the business itself doesn’t pay taxes; instead, the profits and losses are passed through to the individual partners, who report them on their personal tax returns.

Partnerships file a Form 1065, including Schedule K, which is the summary of all distributive items to individual partners. Income and losses are then “passed through” to the individual partners in proportion to their partnership interests on Form 1065 Schedule K-1 regardless of whether the income is distributed to partners in the form of cash.

All partnership business net income is subject to self-employment tax up to 15.3 percent.

Partnerships are legal entities and thus are required to obtain a Federal Employer Identification Number (FEIN).

Partnerships can deduct all “ordinary and necessary” business expenses from their income.

Partners can deduct partnership losses against other ordinary income to the extent of their investment (or their at-risk amount, as discussed in Passive Activities).

However, passive partners (those not actively involved in the enterprise) may not be able to deduct losses due to passive activity rules even if
they are at-risk. Limited partners may not be subject to self-employment tax.

Question 36

Tax Ramifications of Formation of a Partnership

Answer 36

Partners may form a partnership by contributing cash, property, or services to the partnership in exchange for an ownership interest.

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 the property contributed.

If a partner contributes personal or professional services to the partnership, the partner must recognize ordinary compensation income for the value of the services. The amount of income recognized becomes the partner’s basis in his or her partnership interest.

Question 37

Example

Answer 37

Shane would like to become a partner in the Guidry Brothers partnership. Shane contributes the following to Guidry Brothers in exchange for a 50 percent general partnership interest:

• $20,000 cash
• Land with a FMV of $100,000 (Shane’s basis is $80,000
• $10,000 in services

Shane would recognize ordinary income of $10,000, the value of the services he contributed to the partnership. His basis in the partnership interest would be the cash plus his basis in the land plus the ordinary income that he recognized for his services, or $110,000 ($20,000 + $80,000 +
$10,000).

Question 38

Tax Ramification of Business Operation of a Partnership

Answer 38

The partnership must file Form 1065, which is an information return, even though it is not required to pay tax at the entity level.

Each partner’s share of income and expense items is then reported on Form 1065 Schedule
K-1. The partnership is required to provide this form to both the IRS and to each partner.

The partner’s adjusted basis in his partnership interest is adjusted each year to reflect the allocated items of income and expense.
- The partner’s adjusted basis is increased by his share of income, and is decreased by his share of
partnership losses, nondeductible expenses, and distributions.

Question 39

Example

Answer 39

Continuing with the example above, if Guidry Brothers reported earnings of $80,000 for the first year, Shane, a 50 percent partner, would report $40,000 of ordinary income on his federal
income tax return even if no cash was actually distributed. His basis in the partnership after the
first year would be adjusted to $150,000 ($110,000 original basis + $40,000 of allocated
income). Since Shane is a general partner, the $40,000 distributable share of partnership earn-
ings would also be subject to self-employment tax.

Question 40

Tax Ramification of Withdrawals or Distributions from a Partnership

Answer 40

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 a return of capital and, therefore, is not generally taxable. However, the
withdrawal does reduce the partner’s adjusted basis in the partnership.

Once the partner’s basis has been reduced to zero, any additional withdrawals taken from the
partnership will result in a capital gain to the partner.

Question 41

Example

Answer 41

Continuing with the example above, if Shane decides to withdraw $20,000 of his share of the
income, his basis would be reduced to $130,000 ($150,000 - $20,000). Later in the same year,
Shane decides to take a distribution of $140,000 from Guidry Brothers. The first $130,000
reduces his adjusted basis in the partnership to zero and is not taxable because it is treated as a
retum of capital. The last $10,000, however, will be treated as a capital gain to Shane.

Question 42

Advantages of General Partnerships

Answer 42

More sources of initial capital than proprietorships.

Usually have more management resources available than proprietorships.

Have fewer administrative burdens than corporations.

Income and losses are generally passed through to the partners for tax purposes.

Question 43

Disadvantages of General Partnerships

Answer 43

Transfer of interests is more difficult than for 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 generally available to
employees.

Question 44

Limited Partnerships!

Answer 44

What are Limited Partnerships (LP)?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 45

What are Limited Partnerships (LP)?

Answer 45

Limited partnerships are associations of two or more persons as co-owners to carry on a business for profit except that one or more of the partners have limited participation in the management of the venture and thus
limited risk exposure.

If the limited parners participate in the management of the enterprise, they become general partners for liability purposes.

In the normal limited partnership, there
is at least one general partner.

Question 46

Formation

Answer 46

Limited partnerships are generally required to file a partnership agreement or any other required documentation with the domiciliary state to establish the limited partnership.

Those states that require initial filings also require
annual filings to maintain the entity status.

The written partnership agreement specifies which partners are limited partners and which partners are general partners.

Question 47

Interest, Disposal of Interest, and Dissolution

Answer 47

The dissolution and transfer of an interest in a limited partnership is essentially the same as for a general partnership.

Although the limited liability feature might attract more buyers, the inability for limited partners to
have a say in the day-to-day operations of the company is likely to make the transfer of a limited partnership share very difficult.

Question 48

Capital

Answer 48

It is easier to raise capital in a limited partnership than in a general partnership because of the availability of the liability shield for the non-managing limited partners.

However, the limited liability may negatively affect the partnership’s ability to obtain outside financing.

Third party lenders may desire personal guarantees from the partners (which would partially defeat the benefits associated with the limited liability feature).

Question 49

Liability

Answer 49

Liability for limited partners is limited as long as they refrain from participating in the management of the enterprise.

The general partners, who are responsible for the day-to-day operations in a limited partnership, have unlimited liability for enterprise debts and obligations.

Question 50

Examples

Answer 50

Rudy Smith buys a limited partnership interest in Smith Brothers. Unless there is a general partner who also has the last name “Smith,” Rudy may lose his limited liability status.

Amelia invests in a limited partnership. She is interested in participating in the day-to-day man-
agement of the limited partnership. If Amelia is a limited partner, and she actually does participate in the day-to-day management of the limited partnership, she will risk losing her limited
liability status.

Question 51

Management/Operations

Answer 51

A limited partnership is somewhat of a hybrid entity. The general partners run the business and are exposed to personal liability.

The limited partners must avoid making management decisions to protect their limited liability status

Question 52

Income Taxation and Payroll (Social Security) Taxes

A

Answer 52

Timited partners are not usually subject to self-employment tax since they are passive investors who do not participate in management.

The general partners in a limited partnership have self-employment income. As with
the general partnership, the entity files a Form 1065 and issues Schedule K-1s to both its general and limited partners.

Question 53

Advantages of Limited Partnership (LP)

Answer 53

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.

Question 54

Disadvantages of Limited Partnership (LP)

Answer 54

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.

Question 55

Limited Liability Partnerships (LLP)!

Answer 55

What are Limited Liability Partnerships (LLP)?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 56

What are Limited Liability Partnerships (LLP)?

Answer 56

A limited liability partnership (LLP) is a hybrid entity that provides partial liability protection to its member.

The limited liability partnership is generally one comprised of licensed protessionals such as accountants, attorneys, and doctors who practice together.

The partners may enjoy liability protection trom the acts of their other partners, but each partner remains personally liable for his own acts with respect to malpractice.

Question 57

Formation

Answer 57

Limited liability partnerships are generally required to file with the domiciliary state to establish the limited liability partnership.

Those states that require initial filings also require annual filings to maintain the entity status.

Question 58

Interest, Disposal of Interest, and Dissolution

Answer 58

The dissolution and transfer of an interest in a limited partnership is essentially the same as for a general partnership.

If the LLP is comprised of licensed professionals, however, transter of an interest will usually be
more difficult because such interest may only be transferred to another similarly licensed professional.

Question 59

Capital

Answer 59

The amount of capital contributed usually determines the ownership interest in a partnership.

However, sometimes partners allocate ownership interest differently from capital contributed.

Question 60

Liability

Answer 60

A principal disadvantage of the general partnership arrangement is that all general partners in a partnership are subject to joint and several liability for the debts and obligations of the partnership.

However, general partners of an LLP can insulate themselves from liabilities arising from the acts of other partners.

General partners of an LLP will not be personally liable for the debts and obligations arising from
errors, omissions, negligence, incompetence, or acts committed by another partner or representative of the partnership who is not under the supervision or direction of the first partner.

Question 61

Management/Operations

Answer 61

The management of an LLP is generally the same as for any general partnership. Note that unlike a limited partnership, the LLP confers limited liability status on all partners, not just limited partners.

There is limited liability, so they are protected from personal assets being seized for all partners in a LLP.

Question 62

Income Taxation and Payroll (Social Security) Taxes

Answer 62

LLPs are treated as a partnership for federal income tax purposes.

Like a partnership, the LLP is a flow-through entity and is, therefore, not subject to tax at the entity level.

Question 63

Advantages of Limited Liability Partnerships (LLPs)

Answer 63

Favorable pass-through partnership taxation status available.

Flexibility in structuring ownership interests.

Partners can insulate themselves trom the acts of other partners.

Question 64

Advantages of Limited Liability Partnerships (LLPs)

Answer 64

Required to file with the state to register.

Unlimited liability for own acts of malpractice

Question 65

Exam Question

in the beginning of the current year, Ellie’s basis in her LLP interest was S150.000. At the end
or the year, Ellie received a Al from the partnership that showed the following:

• Cash withdrawal of $30,000
• LLP income of $17, 500
• Dividend income or $5,000
• Short-term capital loss of $1,400
• Charitable contributions of $2,900

What is Ellie’s basis in her LLP interest at the beginning of the next year?

a) $31,400
b) $76,400
c) $138,200
d) $150,000

Answer 65

Answer: C

Ellie’s basis in her partnership interest is $138,200. Her original basis of $150,000 is increased by the LLP taxable income of $17,500 and the dividend income of $5,000. Her basis, however, is reduced by the cash withdrawal, short-term capital loss, and charitable contribution. Therefore, her basis is

$138,200

($150,000 + $17,500 + $5,000 - $30,000 - $1,400 - $2,900)

Question 66

Family Limited Partnership (FLP)!

Answer 66

What are Family Limited Partnerships (FLP)?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Taxation

Question 67

What are Family Limited Partnerships (FLP)?

Answer 67

A family limited partnership (FLP) is a special type of limited partnership created under state law with the primary purpose of transferring assets to younger generations using annual exclusions and valuation discounts for minonty interests and lack of marketability.

Question 68

Formation

Answer 68

Usually, one or more family members transfer highly appreciated property that is expected to continue to appreciate to a limited partnership in return for both a small (1 percent, for example) general and a large (99 percent, for example) limited partnership interest.
- In a Family Limited Partnership (FLP), the general partner typically holds a smaller ownership interest compared to the limited partners. The structure often involves the general partner having a minority interest, such as 1 percent, while the limited partners collectively hold the majority interest, such as 99 percent. This arrangement is common in FLPs for estate planning purposes, allowing for the transfer of assets to heirs while maintaining control within the family. The limited partners may benefit from potential income and appreciation, but the general partner retains control over the partnership and its assets.

In a limited partnership, the general partner has unlimited liability and the sole management rights of the partnership, while the limited partners are passive interest holders with limited liability and no management rights.

Question 69

Chart of Formation for FLPs

Answer 69

Question 70

Interest, Disposal of Interest, and Dissolution

Answer 70

Upon creation of the partnership (FLP), there are neither income nor gift tax consequences because the entity created (the limited partnership and all of its interests, both general and limited) is owned by the same person, or
persons who owned it before the transfer.

Once the FLP is created, the owner of the general and limited partnership interests values the limited partnership interests. Since there are usually transferability restrictions on the limited partnership interests (lack of marketability), and since the limited partners have little control of the management of the partnership (lack of
control), limited partnership interests are usually valued at a substantial discount from their fair market values.

It is not uncommon for the discount of such interests to range between 20 and 40 percent for the purpose of calculating gift taxes payable by the transferor. The original transferor (grantor) then begins an annual gifting program utilizing the discounts, the gift tax annual exclusions, and gift-splitting (where applicable) to transfer
limited partnership interests to younger generation family members at reduced transfer costs.

Question 71

Capital

Answer 71

One of the unique features of the FLP, and perhaps its most important non-tax benefit, is that the original owner transferor can maintain control of the property transferred to the limited partnership by only retaining a small general partnership interest.

If the FLP is funded with a business interest, the general partner could remain president of the business, direct the company’s strategic plan, receive reasonable compensation and fringe
benefits, hire and fire employees, receive executive perks, and generally control the limited partners’ interests.

As with all limited partnerships, the limited partners have no control over any of these enumerated management decisions.

The FLP is often undertaken as a series of transfers, including an initial nontaxable contribution of property to the partnership followed by annual exclusion gifts of limited partnership interests.

While a general partner has control over partnership affairs, an individual who transfers his property to an FLP needs to be financially secure without the transferred property, both from a net worth and cash flow perspective

Question 72

Liability

Answer 72

The use of the FLP structure can also help protect family assets. By placing the assets in the FLP and only making gifts of limited partnership interests to heirs, judgments or liens entered against a donee (limited partner) will not jeopardize the assets of the partnership. A donee’s creditor would not be able to force the donee to
liquidate his interest, since the donee does not have the right to force the liquidation of a limited partnership interest.

Transferring limited partnership interests to children and children’s spouses can also help protect assets from divorce claims. If the child and his spouse divorce, even if the divorced spouse received a limited partnership
interest, he or she could not force distributions from the partnership, participate in management, require his or her interest to be redeemed, or force a liquidation of the partnership.

Question 73

Taxation

Answer 73

The creation of family limited partnerships and the use of discounts to transfer value at a lower gift tax cost has been regularly contested by the IRS.

However, in several cases, the courts have ruled in favor of the taxpayer and upheld discounts on the valuation of limited partnership interests in the range of 10 percent to 40 percent, as long as the FLP was operated like a separate business.

The IRS has won, and the valuation discounts have not been allowed in cases where the family withdrew money from the business at leisure, shared checking accounts with the business, had the FLP pay medical or other ordinary living expenses for the family, and when other non business transactions were prevalent within the FLP.

The estate planning benefits of the FLP are lost and expenses are increased (as the result of legal fees) when the IRS successfully contests the use of the FLP arrangement.

To mitigate against this risk and to ensure the use of the favorable discounts, the FLP should possess economic substance by having its own checking accounts, tax identification number, payroll (including payment of reasonable compensation to the general partner if he is
managing the business), and should not allow family members to withdraw funds at will, nor should the FLP pay for personal expenses of its owners.

AFLP is taxed as a partnership and, the entity files a Form 1065 and issues Schedule K-1s to both general and limited partners. The general partner may be a corporation or an individual. The treatment of payroll taxes will be determined by whether the general partner is an individual or a corporation. The limited partners are passive
and not subject to employment tax.

Question 74

Advantages of Family Limited Partnership

Answer 74

Controled retained by senior family member.

Valuation discounts are available for minority interests.

Annual exclusion gifts are generally used to transfer interests to family members.

Some creditor protection

Restrictions can be placed on transferability of limited partnership interests of junior family members.

FL.P is commonly used as an estate planning strategy

Question 75

Disadvantages of Family Limited Partnerships

Answer 75

Attorney setup fees and costs

Periodic valuation costs

Operational requirements

Potential IRS challenges regarding valuations and discounts

Question 76

Limited Liability Companies (LLC)!

Answer 76

What are Limited Liability Companies (LLC)?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 77

What are Limited Liability Companies (LLC)?

Answer 77

Limited Liability Companies are seperate legal entities formed by one or more individuals by meeting state statutory requirements necessary for the formation of an LLC.

Question 78

Formation

Answer 78

LLCs are formed in much the same way as corporations. They are chartered entities registered with the Secretary of State in the state of organization.

The charter document is called Articles of Organization and the state requires the entity to have a resident agent. In addition, the state will require annual filings.

Question 79

Interest, Disposal of Interest, and Dissolution

Answer 79

Usually, owners’ contributions determine the ownership percentage of an LLC. However, sometimes the organization will want to divide the ownership interests in an amount differently than the initial contributions.

They can do this in a variety of ways, including revaluing assets or issuing units for some obligation.

Disposal or transferability of interests may be difficult and may be restricted to transferring only to named parties. Such restrictions are clarified in the operating agreement.

Question 80

Capital

Answer 80

Capital is easier to raise in an LLC than in a proprietorship. Ease of raising capital in an LLC is similar to the ease of raising capital in a partnership.

There is no limitation on the number of members or the types of members in an LLC. Members may include foreign (nonresident aliens) individuals, estate, trusts, corporations, etc.

LLCs may allocate items of income and gains in any manner agreed to by the members in the operating agreement and can also create different classes of ownership interests which have different rights.

Question 81

Liability

Answer 81

The most important feature of an LLC is that the LLC’s individual owners are protected from personal liability for the LLC’s debts and obligations unless they personally guarantee such obligations.

The liability protection is not absolute. Piercing the veil and alter ego concepts give courts the power to disregard the LIC liability protection in extraordinary cases of owner/manager abuse or failure to maintain a clear and continuing identity.

Question 82

Management / Operations

Answer 82

An LLC usually is managed by virtue of an operating agreement. The operating agreement is similar to corporate bylaws and may be amended from time to time. The agreement specifies how and who will manage the LLC, how interests may be transferred, etc.

Operating agreements are not filed with the state. Operating agreements sometimes specify simple majority rules for some decisions, super majority rules for other decisions (e.g., 2/3 or
3/4 to take on debt in excess of certain amounts) and unanimous votes for special situations (e.g., changing the operating agreement).

Caution should be used with unanimous agreement provisions because they essentially
give a minority owner (member) a veto power over all other members.

Note that an LLC is not legally required to have an operating agreement. If an LLC does not have an operating agreement, it will (by default) be governed by the state laws regarding LLCs.

Although this might be sufficient for some LLCs, it is generally best to have a written operating agreement signed by all members that specifies the rules and regulations pertinent to the LLC.

Question 83

Income Taxation and Payroll (Social Security) Taxes

Answer 83

General Taxation

Tax Ramifications of Formation of a Limited Liability Company

Tax Ramifications of Business Operation of a Limited Liability Company

Question 84

General Taxation

Answer 84

An LIC which has a single member/owner is a disregarded entity for federal income tax purposes. The owner must file a Schedule C of Form 1040 for the LLC, the same as for a proprietorship. Such an LLC owner also has the same issues as the proprietors with regard to self-employment tax, unemployment
compensation, and fringe benefits.

An LLC with two or more members can elect to be taxed for federal income tax purposes as a
partnership (Form 1065 with Schedule K-1s), an S corporation (Form 1120S with Schedule K-1s), or a C corporation (Form 1120 with W-2 income to the owners).

Once elected, the tax status (partnership, S corporation, or C corporation) will dictate the handling of self-employment tax and fringe benetits.

As a pass-through entity, an LLC’s income is taxed to members at their personal rates. LLC losses are deductible on personal income tax returns to the extent of basis and may be limited by the passive activity rules.

A unique characteristic of LLCs is that no gain or loss is recognized upon the distribution of appreciated property from an LLC to an LLC member. Gain will only be recognized to the extent that cash received exceeds the members adjusted basis.

LLCs are usually taxed as partnerships. Therefore, members are not generally allowed to exclude from gross income the value of fringe benetits paid on their behalf by the LLC.

LLCs are usually taxed as partnerships. Income earned by the LLC members is normally subject to self-employment tax on the tax returns of individual members. There are exceptions: (1) for LLC income derived from rental real estate, and (2) for LLC members who are not the managing member and are the equivalent of limited partners.

Question 85

Tax Ramifications of Formation of a Limited Liability Company

Answer 85

Generally, limited liability companies are classified as partnerships for federal income tax purposes.

As such the income tax consequences applicable to the formation of an LLC are identical to those
applicable to a partnership.

Question 86

Tax Ramifications of Business Operation of a Limited Liability Company

Answer 86

An LLC with two or more members can be taxed as a partnership or a corporation

If the LLC is classified as a partnership for income tax purposes, the LLC must file an information
return, Form 1065, detailing the items of income and expense that will be reported on the member’s individual income tax return. The members each receive a Schedule K-1 detailing their allocable amounts of income, loss, deduction, and credit.

If the LLC is classified as a corporation, the LLC must file Form1120 and will be responsible for any tax on business income

Question 87

Advantages of a LLC

Answer 87

Members have limited liability.

Number of members is unlimited but a single member LLC is a disregarded entity for tax purposes (File Form 1040 Schedule C).

Members may be individuals, corporations,
trusts, other LLCs, and other entities.

Income is passed through to the members, usually on 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 to members do nor have to be directly proportional to the members’ ownership interests as they do for S corporations.

Can have multiple classes of ownership.

Entity may elect to be taxed as a partnership, an S corporation, or a C corporation.

Question 88

Disadvantages of a LLC

Answer 88

May have limited life (often by termination on the death or bankruptcy of a member).

Transfer of interests 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.

Question 89

C Corporations!

Answer 89

What are C Corporations?

Formation

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 90

What are C Corporations?

Answer 90

Corporations are chartered legal entities formed by one or more individuals by meeting state statutory requirements necessary for the formation of a corporation.

There are two types of corporations: the C corporation and the S corporation.

For tax purposes, S corporations are simply C corporations with a special tax election and
wil be discussed in the next section.

Question 91

Formation

Answer 91

Corporations can only be created by filing a charter document with the state of incorporation (called articles of incorporation).

The articles of incorporation generally require a corporation to disclose its name, number of shares, and the purpose of the corporation.

The corporation’s purpose may be broad
(e.g., to engage in any lawful activity) or specific (e.g., to sell textbooks).

In addition, the corporation will be required to name a registered agent located in the state of incorporation.

Question 92

Interest, Disposal of Interest, and Dissolution

Answer 92

Ownership interests in a corporation are held by a shareholder and are evidenced by shares of stock certificates.

Shares may be easy to transfer if there is a market, but certain small corporations restrict the transfer of shares through a shareholder agreement.

The shares of stock issued by the corporation may be all one class or several classes. Different classes of stock generally have different values and/or voting rights.

Question 93

Capital

Answer 93

Corporations can raise capital more easily than a proprietorship or partnership.

The limited liability status appeals to outside non-employee owner/investors.

Question 94

Liability

Answer 94

Liability in corporations is limited to the invested capital.

Individual shareholders of the corporation have limited liability, presuming the corporation behaves in such a way as to clearly and consistently maintain its identity and
complies with state-mandated requirements.

Question 95

Management/Operations

Answer 95

Corporations are managed by one or more officers appointed by the board of directors. The board of directors is the governing body of a corporation.

The board of directors appoints various officers to run the corporation (usually includes president, chief financial officer, secretary, treasurer). The board of directors acts, or should act. in a very formal way and is required under the corporate charter to meet and follow certain formalities.

Observing corporate formalities, and maintaining good standing with the Secretary of State in the state of incorporation, is an ongoing requirement.

Question 96

Income Taxation and Payroll (Social Security) Taxes

Answer 96

A corporation is taxed as a C corporation unless S corporation status is elected. C corporations must file Form 1120 and pay taxes on their own income on a calendar or fiscal year basis.

The owner/employees of both C
corporations and S corporations are treated as employees for payroll tax purposes. Therefore, the entity withholds 7.65 percent of the employee’s pay for Social Security taxes and matches such withholding for Social
Security taxes. The owner/employee’s compensation is not considered to be self-employment income.

Distributions of cash and other assets to a shareholder/employee in his capacity as a shareholder rather than as an employee are considered to be dividends.

A C corporation is not allowed to take a tax deduction for dividends distributed to shareholders, but shareholders must include the dividends in gross income.

Therefore, the income of a C corporation can be taxed two times, once at the corporation level and a second time at the shareholder
level when dividends are distributed.

In a closely-held corporation, careful tax planning can minimize or even eliminate this double taxation.

When non-cash distributions of appreciated property are made to shareholder/employees, gain must be recognized at the corporate level as though the property had been sold and the cash proceeds distributed.

For a C corporation, this gain must be recognized at the corporation level. For an S corporation, the gain is passed through to shareholders and taxed on their individual income tax returns based on their ownership interests in the S corporation.

Unlike this corporation treatment, appreciated assets can be distributed by an LLC or by any entity taxed as a partnership without any gain recognition at the time of the distribution.

Question 97

Tax Formula for C Corporation

Memorize

Answer 97

Question 98

Corporation Income Tax Rates (2023)

Answer 98

For 2023, corporate tax is a flat rate of 21%.
Pending proposals may change this rate post printing.

Gross income less allowed deductions equals corporate taxable income.

If a corporation incurs a net operating loss after the tax year end December 31, 2017 and the loss is not fully utilized, it can be carried forward indefinitely.

A Personal Service Corporation (PSC) is defined as 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 stock is owned by employees.
- The taxable income of a personal service corporation is taxed at a flat rate of 21 percent!
- Current Administration’s proposed 2023 Budget Plan could alter this number after the print date.

Question 99

Dividend Received Deductions (DRD) Based on Ownership Percentages

Need to Know For Exam

Answer 99

Question 100

Example

Answer 100

Frick Company owns 18% of Frack Company and Frack Company pays a $20,000 dividend
during the year to Frick Company. Frick Company will include the $20,000 dividend in its gross
income. Frick Company, however, will also be entitled to a dividends-received deduction of
$10,000 ($20,000 x50%),

Question 101

Exam Question

Hee Company (a C corporation) owns 15% of Haw Company. During the year, Haw Company
paid a $45,000 dividend to Hee Company. Assuming that Hee Company does not receive dividends from any other corporation, how much will Hee Company’s dividends-received deduction be?
a) $6,750
b) $22,500
C) $36,000
d) $45,000

Answer 101

Answer: B

Hee will include the $45,000 of dividend income in its gross income, but will be entitled to a
dividends-received deduction of $22,500 ($45,000 x50%).

Question 102

Tax Ramifications of Withdrawals or Distributions from a C Corporation

Answer 102

One of the major tax disadvantages of the corporate legal form of business entity is the double taxation of dividends paid by the corporation to its shareholders.

Double taxation occurs because income is taxed at the corporate level and then subsequently taxed again at the individual level because dividends are included in the individual’s income.

Double taxation, however, is not as onerous (burdensome) as it once was because dividends are now taxed at a 15 percent rate for most individual taxpayers.

Owners of a corporation who take a significant salary may run the risk of the IRS reclassifying the
salary as dividend income.

Question 103

Example

Answer 103

Computer Corporation has taxable income of $1,000. Computer Corporation is taxed at the 21
percent rate, Computer Corporation will only have $790 remaining to distribute to its shareholders. Assuming that the 15% rate is applicable to Computer Corporation’s shareholders, the $790 dividend received will result in an additional $118.50 of tax due from the shareholders Consequently, even though the corporation had income of $1,000, the shareholders end up with only $671.50.

Question 104

Advantages of C Corporations

Answer 104

Relative ease of raising capital.

Limited liability of shareholders.

Unlimited life of entity.

Ease of transfer of ownership interests.

Generally more management resources.

Shareholder/employees may receive the full array of employer-provided tax-free fringe benefits.

Question 105

Disadvantages of C Corporations

Answer 105

Potential for double taxation due to entity level taxation.

Administrative burdens (e.g., filings).

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.

Question 106

S Corporations!

Answer 106

What are S Corporations?

Interest, Disposal of Interest, and Dissolution

Capital

Liability

Management/Operations

Income Taxation and Payroll (Social Security) Taxes

Question 107

What are S Corporations?

Answer 107

An S corporation is normally created under state law by first forming a C corporation and then filing an “S” election with the IRS. The incorporation is normally the same as for a C corporation. There are, however, significant ways in which an S corporation differs from a C corporation.

A corporation must meet all of the following requirements at all times for the “S” election to be initially and continually valid:

• An S corporation cannot have more than 100 eligible shareholders.
• Ownership of S corporation stock is restricted to individuals who are US citizens or US residents,
  estates, certain trusts, and charitable organizations.
• An EST (Electing Small Business Trust) is on the of the trusts that can own an S Corporation.
• The corporation must be an eligible corporation created under the laws of the United States or of any state.
• Insurance companies, Domestic International Sales Corporations (DISCs), and certain financial
  institutions are not eligible for S corporation status.
• The corporation is allowed only one class of outstanding stock.
• An S corporation may have one class of stock, however, the one class of stock may have shares with voting rights and shares with no voting rights.

Question 108

Exam Tip

Answer 108

Make a flashcard of the S corporations requirements. You need to know whether you can recommend an S corporation or not.

Question 109

Interest, Disposal of Interest, and Dissolution

Answer 109

Like a C corporation, the ownership interests in an S corporation are held by shareholders and are evidenced by shares of stock.

Transferability of shares may be restricted by shareholders agreement.

Question 110

Capital

Answer 110

It is easier to raise capital in an S corporation than in a proprietorship or partnership because of the limited liability protection.

However, the limited number of allowable shareholders may have a negative affect on the
ability to raise capital.

Recent changes in the IRC allow close family members to be treated as a single shareholder.

Question 111

Liability

Answer 111

An S corporation offers the same limited liability protection as a C corporation or an LLC.

The shareholders’ liability for the acts omissions, debts, and other obligations of the corporation generally is limited to the shareholders’ capital contributions.

There are several situations, however, in which the S corporation’s shareholders will be personally liable for the debts of the corporation:

• A lender to a closely held corporation requires that the primary shareholders guarantee the loan to the corporation. If this is the case, the shareholders are liable to the extent of their guarantees, in addition to their capital contribution.
• A court may ignore the legal fiction of the corporation as an entity (pierce the corporate veil) when the corporation has been used to perpetuate fraud, circumvent law, accomplish an illegal purpose, or otherwise evade law.

The courts may disregard the corporate form of entity if the corporation is not maintained as a separate entity from its shareholders. This arises occasionally in the case of closely held corporations.

Question 112

Management / Operations

Answer 112

Corporations are managed by one or more officers appointed by the board of directors. The board of directors is the governing body of a corporation.

The board of directors appoints various officers to run the corporation. The board of directors acts, or should act, in a very formal way and is required under the corporate charter to meet and follow certain formalities.

Observing corporate formalities and maintaining good standing with the Secretary the state of incorporation is an ongoing requirement.

Question 113

Income Taxation and Payroll (Social Security) Taxes

Answer 113

General Taxation

Tax Ramifications of Formation of an S Corporation

Tax Ramifications of Business Operation of anS Corporation

Tax Ramifications of Withdrawals or Distributions from an S Corporation

Question 114

General Taxation

Answer 114

The income of an S corporation is passed through to shareholders and is not taxed at the corporation level. Therefore, an S corporation provides many of the benefits of a corporation without any double taxation of income earned by the corporation.

The owner/employees of S corporations are employees for payroll tax purposes. Therefore, the entity withholds 7.65 percent of the employees’ pay for Social Security taxes and matches such withholding for Social Security taxes. The owner/employee compensation is not considered self-employment income. Additional distributions to shareholders beyond reasonable compensation are treated as dividends not subject to payroll tax.

Since the income of an S corporation is taxed to the shareholders for the year in which it is earned, dividend distributions to shareholders are normally not subject to income tax at the time they are distributed. Stated differently, S corporation dividends normally represent the distribution of income that has previously been taxed to the shareholder.

As indicated in the C corporation discussion, in-kind distributions of appreciated assets will be treated as a deemed sale; thus, such distributions will generate a capital gain in the case of an S corporation to all shareholders in proportion to their ownership even if the asset was only distributed to one shareholder.

Generally, S corporations file Form 1120S on a calendar year basis and provide each shareholder with a Form 1120S Schedule K-1.

Question 115

Tax Ramifications of Formation of an S Corporation

Answer 115

An S Corporation is formed in the same manner as a C corporation.

Conceptually, the computation of a shareholder’s basis in S corporation stock is similar to that for
partners in a partnership.

Both calculations are designed to ensure that there is neither a double taxation of income nor double deduction of expenses.

Question 116

Tax Ramifications of Business Operation of an S Corporation

Answer 116

The S corporation itself is generally not required to pay income tax at the entity level.

The S corporation must, however, file an information return, Form 1120S.

Shareholders must take into account their pro rata share of corporate taxable income and any separately stated items in computing their taxable incomes.

Each shareholder’s distributive share of items is reported on Schedule K-1, which is furnished by the S corporation to both the IRS and the shareholder.

Ordinary income allocated to a shareholder from an S corporation is NOT subject to self employment tax.

The shareholder’s taxable basis in the stock must be adjusted each year to reflect the allocated items of income and exense.

• Adjusted basis is increased by a shareholder’s distributive share of both taxable and nontaxable
  S corporation income and is decreased by the shareholders share of S corporation losses, nondeductible expenses, and distributions.

Question 117

Example

Answer 117

Henry is a 25% owner of an S corporation, and he performs services for the business. Henry
receives a salary from the S corporation, but he is not required to pay self-employment tax
any income from the S corporation.

Shareholder that receives income from a S corporation is NOT subject to self-employment tax.

Question 118

Exam Question

During the year, Susan purchased 24 shares of an S corporation’s 200 shares of common stock outstanding. She held the shares for 219 days during the taxable year. If the S corporation reported taxable income of $300,000, what must Susan include on her personal income tax return?

a) $21,600
b) $36,000
c) $43,200
d) $72,000

Answer 118

Answer: A

Susan must include $21,600 on Schedule E of her personal income tax return. She held a 12% interest in the corporation for 219 days during the year.

Calculation: $300,000 x ( 24 ÷ 200 ) x ( 219 ÷ 365 )
=$21,600

Question 119

Tax Ramifications of Withdrawals or Distributions from an S Corporation

Answer 119

The rules regarding distributions from an S corporation to a shareholder generally follow the rules applying to distributions from partnerships.

Distributions from S corporation are considered nontaxable (return of capital) to the extent of the shareholder’s basis in the stock. Any dsitributions in excess of the stock adjusted basis is treated as capital gain.

Question 120

Advantages of S Corporations

Answer 120

Income is passed through to the shareholders for federal income tax purposes.

Income is taxed at the individual level which may be a 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

Question 121

Disadvantages of S Corporations

Answer 121

Limited to 100 shareholders

Only one class of stock is permitted

Cannot have corporate, partnership, certain trust, or nonresident 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.

Question 123

Personal Holding Company

Answer 123

A personal holding company is defined in Internal Revenue Code section 452. Basically, a corporation is a personal holding company if both of the following requirements are met:

Personal Holding Company Income Test. At least 60% of the corporation’s adjusted ordinary gross
income for the tax year is from dividends, interest, rent, and royalties.

Stock Ownership Requirement. At any time during the last half of the tax year, more than 50% in value of the corporation’s outstanding stock is owned, directly or indirectly, by 5 or fewer individuals.

Question 124

Exam Tip

Answer 124

Personal Holding Company is infrequently tested. Just know the defintions.

Question 125

Selecting the Proper Business Legal Form: Proprietorship

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 125

1. Low
2. Yes
3. No
4. One
5. Owner
6. Schedule C 1040
7. No
8. Individual
9. Self-Employment

Question 126

Selecting the Proper Business Legal Form: General Partnership

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 126

1. Medium
2. Yes
3. Generally Not
4. Unlimited
5. Partner
6. Form 1065 K-1 flows to Schedule E of 1040.
7. Yes
8. Flow Through
9. Self Employment but limited partners / members are not subject to Social Security tax unless they perform professional services for the entity.

Question 127

Selecting the Proper Business Legal Form: Limited Partnership

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 127

1. Medium - High
2. No (only if limited partners)
3. Yes
4. Unlimited
5. Partner or Limited Partner
6. Form 1065 K-1 flows to Schedule E of 1040.
7. Yes
8. Flow Through
9. Self Employment but limited partners / members are not subject to Social Security tax unless they perform professional services for the entity.

Question 128

Selecting the Proper Business Legal Form: LLP

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 128

1. High
2. Yes
3. Yes
4. Unlimited
5. Partner or Limited Partner
6. May file as Corporation or Partnership
7. Yes
8. Flow Through
9. Self Employment but limited partners / members are not subject to Social Security tax unless they perform professional services for the entity.

Question 129

Selecting the Proper Business Legal Form: FLP

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 129

1. High
2. Yes
3. Yes
4. Unlimited
5. Partner or Limited Partner
6. Form 1065 K-1 flows to Schedule E of form 1040.
7. Yes
8. Flow Through
9. Self Employment but limited partners / members are not subject to Social Security tax unless they perform professional services for the entity.

Question 130

Selecting the Proper Business Legal Form: LLC

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 130

1. High
2. No
3. Yes
4. Unlimited
5. Members
6. If one member, entity is disregarded and owner has files Schedule C of Form 1040. If two or more members, choice of Form 1065 (Partnership), Form 1120-S (S Corp), or Form 1120 (C Corp).
7. No, if one member. Yes, two or more members.
8. Flow Through
9. Depends on filing choice, but limited partners / members are not subject to Social Security Tax unless they perform professional services for the entity.

Question 131

Selecting the Proper Business Legal Form: S Corp

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 131

1. High
2. No
3. Yes
4. 100
5. Shareholders
6. Form 1120S k-1 to shareholders.
7. Yes
8. Flow Through
9. W-2 and ordinary income Excess profits distributed are not subject to Social Security tax.

Question 132

Selecting the Proper Business Legal Form: C Corp

1. Cost to Create (money & time)
2. Personal Liability of investors for enterprise debt
3. Annual State Filing Requirements
4. Maximum Owners
5. Owners are known as
6. Tax Filing Alternatives
7. Federal Tax ID Required
8. Taxation Concept
9. Owners Income

Answer 132

1. High
2. No
3. Yes
4. Unlimited
5. Shareholders
6. Form 1120
7. Yes
8. Entity
9. W-2 and dividend income.

Question 133

Given the following information, select or avoid these entities:

Answer 133

1. If you have significant personal income and you expect the business to have losses, consider flow through entities.
2. If you want to be able to allocate income/losses in percentages different than ownership, select an LLC taxed as a partnership.
3. If you are converned about liability, avoid sole proprietorships and general partnerships.
4. If signifcant income is expected from the business, then consider a C corporation.

Question 134

Pass Through Means?

Answer 134

Partnerships can deduct all “ordinary and necessary” business expenses from their income.

Partners can deduct partnership losses against other ordinary income to the extent of their investment (or their at-risk amount, as discussed in Passive Activities).

This refers to Pass Through not necessarily partners.

Question 135

Deduction for Business Income From Pass Through Entities and Sole Proprietorships

Answer 135

For tax years 2018 - 2025, an individual generally may deduct 20% of Qualified Business Income from a partnership, S corporation, or sole proprietorship, as well as 20% of aggregate qualified Real Estate Investment Trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. The 20% deduction is not allowed in computing Adjusted Gross Income (AGI), but rather is allowed as a deduction reducing taxable income.

A limitation based on W-2 wages paid is phased in for married filing joint taxpayers with taxable
income of $364,200 or more ($182,010 for other individuals) in 2023. A dis-allowance of the deduction with respect to specified service trades or businesses also is phased in above these threshold amounts of taxable income. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or
skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests.

Question 136

Exam Question

Which of the following entities provides limited liability for all owners?
1. Limited Partnership
2. Corporation
3. S Corporation

a) 3 only.
b) 1 and 2 only,
C) 2 and 3 only.
d) 1, 2, and 3

Answer 136

Answer: C

Limited partnerships only provide limited liability for limited partners. Limited partnerships are
required to have at least one general partner, who has unlimited liability.

Question 137

Exam Question

Allison is a doctor who is investing in a new business that she expects to experience losses in the first year. Allison is concerned about protecting her personal assets. Which entity would you recommend?

a) Sole proprietorship
b) S corporation.
c) C corporation.
d) Partnership

Answer 137

Answer: B

An S corporation provides flow-through accounting so she can offset ordinary income with business losses. Option D is not appropriate because the question did not indicate that she has any partners.

Question 138

Exam Question

Pat owns 100% of PH, Inc. PH, Inc. owns 80% of RM, Inc. RM, Inc. pays dividends. Which of
the following entities would benefit the most from RM’s dividend payments?

a) S corporation.
b) C corporation.
C) Sole proprietorship
d) LLC.

Answer 138

Answer. B

C corporations are entitled to a dividends-received deduction of 100% if they own 80% or more of the company paying the dividend.