Tax Lesson 5 Flashcards
Selection process for entities includes consideration of factors:
Ease & cost of formation
Complexity of management & governance
How transferability & dissolution are achieved
Liability protection for owners’ personal assets
Reporting requirements & taxation
Entities almost always formed under
State law
Proprietorships & general partnerships
Less complex, inexpensive, easy to form
Requirements for registration may include:
Initial registration with state
Annual filing requirements
State imposed operational requirements
Proprietorships can be dissolved
At election of owner with no formal steps
Liability protection
Not available for proprietorships, general partnerships, nor general partners of limited partnership & only to limited extent for LLPs
For limited liability protection to continue
Entity must alert public to limited liability status in clear & identifiable manner
Failure to identify status pierced the veil & could result in personal liability of owners
To avoid piercing the veil: keep business & personal books/records separate, follow corporate formalities, address content in contracts/correspondence from view point of business entity not owners
Also maintain reasonable amount of liability insurance & be vigilant in meeting formalities
Sole Proprietorships
1 individual
No filings, filing fees, transfer of assets
Formation easy & inexpensive
If collecting sales tax, register with state or local taxing authority
100% ownership interest, easy to self if find a buyer
Dissolution by discontinuing business & paying creditors or death
Capital limited to resources of proprietor
Unlimited legal liability
No guarantee of continuity
Sole Prop Tax
Add schedule c to 1040
Use SSN unless employees then need EIN
No unemployment taxes on self, only employees
Does pay self-employment tax (15.3%) on own earnings & 1/2 SS taxes for employees
Can deduct all ordinary & necessary business expenses from gross income (deductions part 2 of schedule c)
Profit/loss from schedule c carried over to 1040
May make qualified contributions to retirement plan
To calculate self employed contribution to Keogh plan, use formula
Keogh Contribution
1) self employment income x 92.35%
12.4% of $147k
Plus 2.9% all income
Equals self employment tax
Self employed contribution rate = contribution to others/1+ contribution to others
2) net self employment income - 1/2 self employment taxes = adjusted net self employment income x contribution rate = self employed contribution
25% compensation limit for
Deductible employee contributions
Advantages of sole prop
Easy to form Simple to operate Easy to sell business assets Few admin burdens Income passed through schedule c 1040
Disadvantages of sole prop:
Limited sources of capital
Unlimited liability
No guarantee of continuity
Business income subject to self-employment tax
General Partnerships
Joint
Not required to register with Secretary of State
Each general partner participate fully in management & act with full authority
Equal ownership/profits/loss unless specified
Usually have voting power proportionate to interest
Difficult to dispose of interest
Dissolution either voluntary or judicial (when don’t agree - most likely to arise when required unanimous)
Should have written agreement about interests & distributive share of profits/losses
Unlimited liability
Relaxed formalities
Employees able to receive tax free fringe benefits; not true for partners (can participate in qualified plan subject to limitations of sole prop)
General Partnership Taxation
Not taxed at entity level
Form 1065 schedule k
Net income subject to self employment tax (15.3%)
Required to obtain EIN
Can deduct all ordinary & necessary business expenses from income
Can deduct losses against ordinary income to extent of investment/at risk amount
For contributions of services partner must recognize ordinary compensation income for value of services; amount recognized becomes basis
Basis adjusted each year (increased by income, decreased by losses, non deductible expenses, distributions)
Withdrawals not taxable but do reduce basis; additional withdrawals beyond basis considered capital gain
Advantages of Partnerships
More sources of initial capital
More management resources available
Fewer admin burdens
Income/losses passed through for tax purposes
Disadvantages of Partnerships
Transfer of interests more difficult
Unlimited liability
Income tax & basis adjustment results complex
Business net income subject to self employment tax
Partners entitled to few tax-free fringe benefits
Limited Partnerships
2 or more
If limited participate in management become general
Usually at least one general partner
File partnership agreement - establishes who limited & who general
Dissolution same as general partnership
Transfer of limited difficult
Easier to raise capital because of liability shield for limited partners
General partners still have unlimited liability
Income Tax for Limited Partnerships
Limited partners not subject to self employment tax
Form 1065 & schedule k1
Advantages of Limited Partnerships
Pass through tax status
Flexibility in structuring interests
Limited partners not personally liable as long as don’t engage in management
Disadvantages of Limited Partnerships
Must file with state to register
General partners liable for debts/obligations
Losses generally passive losses for limited partners
Limited Liability Partnerships
Typically licensed professionals practicing together
Limited liability except for personal liability & malpractice
File with state to register; likely annual filings
Dissolution same for partnership (can be difficult due to finding similarly licensed professional)
Amount of capital contributed determines interest
Not personally liable for acts of other partners
Treated as partnership for tax
Flow through - not taxed at entity level
Advantages of LLP
Pass through taxation
Flexibility in structuring ownership interests
Partners can insulate selves from acts of other partners
Disadvantages of LLP
Required to file with state to register
Unlimited liability for own acts of malpractice
Example Exam Question: Basis in LLP was $150j. Receive k1 from partnership showing the following: Cash withdrawal $30k LLP income $17500 Dividend income $5000 STCL $1400 Charitable contributions $2900 What is new basis?
A. $31400
B. $76400
C. $138200
D. $150000
C
Family Limited Partnerships
Primary purpose of transferring to younger generations using annual exclusions & valuation discounts for minority interests & lack of marketability
Usually transfer highly appreciated property that is expected to continue appreciating in return for small general & large limited partnership interests
No income or gift tax consequences upon creation
Owner values limited partner interests
Usually transferability restrictions
Usually valued 20-40% discount from FMV for calculating gift tax payable
Original owner/transferor can maintain control
Often a series of transfers
Individual who transfers to FLP needs to be financially secure without transferred property from net worth & cash flow perspective
Can help protect assets from creditors & in case of divorce
Taxation of FLPs
Keep within 10-40% discount & keep FLP as separate books from personal
Run it like a business
Taxed as partnership
Form 1065 k1 to general & limited partners
General partner may be individual or corporation
Limited partners passive & not subject to employment tax
Advantages of FLPs
Control retained by senior family member
Valuation discounts available for minority interests
Annual exclusion gifts generally used to transfer interests
Some creditor protection
Restrictions can be placed on transferability of limited partnership interests of junior family members
Commonly used as estate planning strategy
Disadvantages of LLP
Attorney setup fees & costs
Periodic valuation costs
Operational requirements
Potential IRS challenges regarding valuations & discounts
Limited Liability Companies
1 or more meeting state statutory requirements
Register with Secretary of State
Articles of Organization
Resident agent
Annual filings
Contributions usually determine ownership
Disposal/transfer can be difficult & May be restricted - clarified in operating agreement
Easier to raise capital
No limit on number or type of members
Limited liability unless pierce the veil
Management determined by operating agreement (not filed with state)
May have simple majority, super majority, or unanimous votes
Not legally required to have operating agreement / governed by state laws
Taxation on LLCs
Single owner schedule c on 1040; like sole prop
More than 1 owner: elect partnership, s corp, or c corp
Tax status will dictate self employment tax & fringe benefits
No gain recognized on distribution of appreciated property unless exceeds basis
Usually taxed as partnerships (except rental real estate income, & LLC members not managing member)
Advantages of LLCs
Limited liability
Number of members unlimited
Single member LLC disregarded entity for tax purposes
Income passed through to members k1
Double taxation avoided in partnership elected
Members can participate in managing LLC
Distributions do not have to be directly proportional to ownership interests
Can have multiple classes of ownership
Can elect tax status
Disadvantages of LLCs
May have limited life
Transfer of interests is difficult & sometimes limited by operating agreement
Some industries/professions not permitted to use LLC status
Laws vary from state to state
Laws are relatively new; less precedent from prior court cases
Complex partnership rules for tax purposes
Members not meeting exceptions subject to self employment tax on all earned income if partnership status
C Corporations
Chartered legal entities
File charter document with state
Articles of incorporation disclose name, number of shares, purpose of corp (May be broad or specific)
Required to name registered agent
Shares may be easy to transfer if there is a market, May be restrictions through shareholder agreement
May be all one class or several classes of stock shares
Easily raise capital
Limited liability to invest capital
Managed by one or more officers appointed by board of directors
Board is governing body - appoints various offices
Board should operate very formally
C Corp Taxation
Form 1120
Pay taxes on own income
Owner/employees treated as employees for payroll tax purposes
Entity withholds 7.65% for SS & matches withholding for SS tax
Owner/employees comp not subject to self employment
Distributions in capacity as shareholder considered dividends
C corp not allowed to take deductions for dividends but shareholders must include in income
Double taxation
Non-cash distributions of appreciate property: gain must be recognized at corporate level as though had been sold & cash proceeds distributed
Gain recognized at corporate level
Corporation Income Tax Rates
Corporate tax is flat rate of 21%
Dividend Received Deductions (DRD)
Ownership <20%: 50%
Between 20-80%; 65%
80%+: 100%
Example Exam Question:
C corp owned 15% of company. Company paid dividend to corp of $45000. Does not receive dividends from any other corp. How much will corp’s drd be?
A. $6750
B. $22500
C. $36000
D. $45000
B
C corp net operating loss
Carried forward indefinitely
Personal Service Corporation
C corp
Services of Health, law, engineering, architecture, accounting, actuarial service, consulting & substantially all stock owned by employees
Taxes at 35%
Tax C Corp
Double taxation of dividends
15% for taxpayers typically
Owners who take significant salary may have IRS reclassify salary as dividend income
Advantages of C Corps
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 full array of employer provided tax free fringe benefits
Disadvantages of C Corps
Potential for double taxation Admin burdens More difficult to form Dissolution can cause taxable gains Borrowing may be difficult Requires registered agent Requires federal tax id number
S Corporations
First forming c corp then filing s election with IRS
Cannot have more than 100 eligible stockholders
Ownership restricted to US citizens/residents, estates, certain trusts, & charitable organizations (ESBT trust can)
Corp must be eligible created under laws of US or any state
Insurance companies, domestic international sales corporations (discs), & certain financial institutions not eligible for s status
One or more officers from bird of directors
Only allowed 1 class outstanding stock
Stock can have shares with & without voting rights
Ownership evidenced by shares of stock
Easier to raise capital
IRC allow close family members to be treated as single stockholder
Limited liability unless:
Lender requires loan guarantee
Pierce the veil (fraud, circumvent law, illegal purposes)
If not maintained as separate entity
S corp taxation
Pass through income
Owner/employees considered employees
7.65% SS tax withheld
Not considered self employment income
Distributions beyond reasonable compensations treated as dividends not subject to payroll tax
In kind distributions of appreciated assets treated as sale/capital gain to all shareholders in proportion to ownership even if only distributed to one shareholder
Form 1120s schedule k1
Not required to pay tax at entity level
Taxable basis adjusted each year
Increased by distributive share of both taxable & non taxable s corp income
Decreased by share of losses, non deductible expenses, & distributions
Distributions non taxable up to basis
Example Exam Question:
Purchased 24 share of s corp’s 200 shares of common stock outstanding. Held for 219 days in taxable year. If S corp reported taxable income of $300000, what amount included on personal tax return?
A. $21600
B. $36000
C. $43200
D. $72000
A
Advantages of S Corps
Income passed through to shareholders
Taxes at individual level which may be lower than applicable corporate rate
Limited liability
Distributions exempt from payroll tax system assuming adequate compensation to shareholder/employees
Disadvantages of S Corps
Limited to 100 shareholders
Only 1 class of stock
Cannot have corporate, partnership, certain trust, or nonresident alien shareholders
Shareholder employees owning more than 2% of company must pay taxes on range of employee fringe benefits that would be tax free to shareholder/employee of c corp
Tax rate on individual May be higher than corporate tax rate
Borrowing may be difficult without stockholder personal guarantees
Personal Holding Company
Both:
Personal holding income test: at least 60% of corp’s AGI from dividends, interest, rent, & royalties
Stock ownership requirement: any time during last half of tax year more than 50% in value of outstanding stock owned directly/indirectly by 5 or fewer individuals
If you have significant personal income & expect business to have a loss
Flow through entities
If want to be able to allocate income/losses in percentages different than ownership
LLC taxed as partnetship
Concerned about liability
Avoid sole prop & general partnerships
If significant income expected from business
Consider c corp
Example Exam Question: Which provides limited liability for all owners? 1. Limited partnership 2. Corporation 3. S corporation
A. 3
B. 1,2
C. 2,3
D. 1,2,3
C
Example Exam Question:
Doctor investing in new business. Experience losses in first year. Concerned about protecting personal assets. Which entity do you recommend?
A. Sole prop
B. S corp
C. C corp
D. Partnership
B
Example Exam Question:
Owns 100% ph inc. ph inc owns 80% rm inc. rm inc pays dividends. Which would benefit most from rm dividend payments?
A. S corp
B. C corp
C. Sole prop
D. LLC
B
Deduction for qualified business income
20% for partnership, s corp, sole prop
As well as aggregate qualified real estate investment trust dividends, qualified cooperative dividends & qualified publicly traded partnership income
Not allowed in computing AGI but is an allowable deduction reducing taxable income
Limitation based on w2 income $170,050 (single) phaseout
Lesson 5 Review:
CPA performed services from partnership & in lieu of normal fee accepted 15% unrestricted capital interest in partnership with FMV of $10k. How much income should be reported on tax return?
A. $0
B. $1500
C. $10000
D. $66667
C
Lesson 5 Review: S corp had following info for tax year: Net income: $60k Salary to employee: $18k Rental income: $22k Rental expenses: $29k Net income: $35k 40% owner in s corp performs services What is self employment income from corporation abject to self employment tax?
A. $0
B. $2670
C. $35000
D. $60000
A
Lesson 5 Review:
During year purchase 5 shares of s corp’s 100 shares. Held for 146 days during tax year. If s corp reported taxable income of $300k, what amount must be included on personal tax return?
A. $0
B. $6000
C. $15000
D. $120000
B
Lesson 5 Review: Partnership basis was $100k. Received following information: Cash withdrawal: $60k Partnership income: $35k Dividend income: $10k STCL: $2800 Charitable contribution: $5800 What is new basis?
A. $31400
B. $76400
C. $100000
D. $145000
B
Lesson 5 Review:
C corp owns 25% company. Company paid dividend of $30k to c corp. Assuming does not receive dividends from any other corp, how much will dividends received deduction be?
A. $0
B. $10k
C. $19500
D. $30k
C
Lesson 5 Review:
S corp showed following income/distributions each year:
Yr 1: taxable income $55k, distributions $35k
Yr 2: ti $60k, d $25k
Yr 3: ti $50k, d $35k
Yr 4: ti $40k, d $50k
Company has had single shareholder since beginning & basis was $10k. What is basis at end of year 4?
A. $5k
B. $10k
C. $70k
D. $215k
C
Lesson 5 Review: Received 70% capital interest in general partnership by contributing: Land: basis 60 fmv 100 Debt on land: fmv -50 Inventory: basis 10 fmv 8 Services: fmv 2500 What is basis after contribution?
A. $20k
B. $57,500
C. $70k
D. $110,500
B
Lesson 5 Review:
General partner in general partnership. Received k1 which contained:
Taxable income: $200k
Dividend income: $2500
LTCG: $6000
How much self employment tax will have to be paid?
A. Not required
B. $14,130
C. $17,707
D. $23,584
D
Lesson 5 Review:
Which is not requirement of a corp status?
A. Must have at least 2 classes of stock
B. May not have more than 100 shareholders
C. Nonresident alien not an eligible shareholder
S corp must be created under laws of US or any state
A
