Lesson 5 of Income Tax Planning: Entities Flashcards

Question

Advantages of Sole Proprietorships

Answer 1

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

Answer 2

Generally have limited sources of capital Unlimited liability No guarantee of continuity beyond the proprietor Business income is subject to self-employment tax

Answer 3

What are General Partnerships? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 4

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.

Answer 5

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.

Answer 6

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.

Answer 7

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.

Answer 8

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.

Answer 9

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).

Answer 10

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

Answer 11

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.

Answer 12

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.

Answer 13

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).

Answer 14

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.

Answer 15

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.

Answer 16

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.

Answer 17

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.

Answer 18

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.

Answer 19

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.

Answer 20

What are Limited Partnerships (LP)? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 21

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.

Answer 22

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.

Answer 23

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.

Answer 24

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).

Answer 25

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.

Answer 26

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.

Answer 27

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

Answer 28

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.

Answer 29

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.

Answer 30

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.

Answer 31

What are Limited Liability Partnerships (LLP)? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 32

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.

Answer 33

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.

Answer 34

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.

Answer 35

The amount of capital contributed usually determines the ownership interest in a partnership. However, sometimes partners allocate ownership interest differently from capital contributed.

Answer 36

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.

Answer 37

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.

Answer 38

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.

Answer 39

Favorable pass-through partnership taxation status available. Flexibility in structuring ownership interests. Partners can insulate themselves trom the acts of other partners.

Answer 40

Required to file with the state to register. Unlimited liability for own acts of malpractice

Answer 41

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)

Answer 42

What are Family Limited Partnerships (FLP)? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Taxation

Answer 43

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.

Answer 44

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.

Answer 45

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.

Answer 46

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

Answer 47

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.

Answer 48

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.

Answer 49

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

Answer 50

Attorney setup fees and costs Periodic valuation costs Operational requirements Potential IRS challenges regarding valuations and discounts

Answer 51

What are Limited Liability Companies (LLC)? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 52

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.

Answer 53

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.

Answer 54

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.

Answer 55

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.

Answer 56

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.

Answer 57

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.

Answer 58

General Taxation Tax Ramifications of Formation of a Limited Liability Company Tax Ramifications of Business Operation of a Limited Liability Company

Answer 59

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.

Answer 60

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.

Answer 61

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

Answer 62

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.

Answer 63

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.

Answer 64

What are C Corporations? Formation Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 65

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.

Answer 66

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.

Answer 67

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.

Answer 68

Corporations can raise capital more easily than a proprietorship or partnership. The limited liability status appeals to outside non-employee owner/investors.

Answer 69

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.

Answer 70

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.

Answer 71

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.

Answer 72

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.

Answer 73

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%),

Answer 74

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%).

Answer 75

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.

Answer 76

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.

Answer 77

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.

Answer 78

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.

Answer 79

What are S Corporations? Interest, Disposal of Interest, and Dissolution Capital Liability Management/Operations Income Taxation and Payroll (Social Security) Taxes

Answer 80

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.

Answer 81

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

Answer 82

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.

Answer 83

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.

Answer 84

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.

Answer 85

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.

Answer 86

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

Answer 87

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.

Answer 88

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.

Answer 89

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.

Answer 90

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.

Answer 91

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

Answer 92

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.

Answer 93

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

Answer 94

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.

Answer 95

**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.

Answer 96

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

Answer 97

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

Answer 98

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.

Answer 99

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.

Answer 100

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.

Answer 101

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.

Answer 102

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.

Answer 103

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.

Answer 104

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

Answer 105

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.

Answer 106

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.

Answer 107

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.

Answer 108

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.

Answer 109

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.

Answer 110

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.