Chapter 10 Sole Proprietorships and FlowThrough Entities 2005

Chapter 10 Sole Proprietorships and Flow-Through Entities © 2005 Prentice Hall, Inc. 10 - 1

Flow-Through Entity l l An operating business whose net income (and certain other items) pass directly through to the owners The items passed through are included with the owners’ other income/loss items for taxation © 2005 Prentice Hall, Inc. 10 - 2

Flow-Through Entities l l l Sole proprietorship General partnership Limited liability company (LLC) Limited liability partnership (LLP) S corporation © 2005 Prentice Hall, Inc. 10 - 3

Sole Proprietorship l l l One owner business that is easy to form Owner (sole proprietor) must be an individual Sole proprietor has unlimited liability Business uses same tax year as owner Owner has no capital account and no basis in the business as a whole Ø l Basis of personal assets contributed is lesser of their adjusted basis or FMV Owner must establish that the business is legitimate and not a hobby © 2005 Prentice Hall, Inc. 10 - 4

Sole Proprietorship l l Owner uses Schedule C (or C-EZ) to report proprietorship income and expenses Some transactions are not included in business operating income Investment income and expenses Ø Capital gains and loses Ø Section 1231 gains and losses Ø Charitable contributions Ø © 2005 Prentice Hall, Inc. 10 - 5

Sole Proprietorship l Proprietor maintains an office in the home Allocated space must be used exclusively and on a regular basis for the business Ø Deduction is limited to taxable income from business after deducting all other business expenses Ø Expenses related to use are separately reported on Form 8829 Ø © 2005 Prentice Hall, Inc. 10 - 6

Sole Proprietorship l Sole proprietor does not receive a salary Ø l Taxed on the entire net income (or deducts the loss) from Schedule C on Form 1040 Sole proprietor is not eligible for tax-free employee fringe benefits Ø Ø Ø Can deduct own health insurance premiums for AGI Can deduct contribution to own retirement account for AGI Can hire spouse as employee and spouse can then participate in fringe benefits © 2005 Prentice Hall, Inc. 10 - 7

Self-Employment Taxes l Self-employed individuals (sole proprietors, general partners, and managing members of LLCs) must pay self-employment taxes (Social Security and Medicare) Ø Deduction allowed for 50% of selfemployment tax for AGI © 2005 Prentice Hall, Inc. 10 - 8

Partnerships l l A partnership is a relationship between 2 or more individuals (or other entities) to operate a business and share profits No limit on number of partners There are no restrictions on who can be a partner (any type of entity, including an individual, another partnership, a corporation, an estate, or a trust) Most LLCs are partnerships for tax purposes © 2005 Prentice Hall, Inc. 10 - 9

General Partnership l General partnerships have only general partners Ø Ø Ø General partners are personally liable for all debts of the partnership General partners have an active role in management General partners have the authority to bind the partnership with respect to third parties © 2005 Prentice Hall, Inc. 10 - 10

Limited Partnership l Limited partnerships have at least one general partner and at least one limited partner Ø Ø Ø Limited partner’s liability is limited to invested capital Limited partners are not permitted to have an active role in the management of the partnership Limited partners do not have the authority to bind the partnership with respect to third parties © 2005 Prentice Hall, Inc. 10 - 11

Limited Liability Partnership l l l The LLP is a general partnership that conducts a business providing professional services Partners in an LLP are fully liable for the general debts of the partnership This entity protects partners from liability for malpractice of other partners © 2005 Prentice Hall, Inc. 10 - 12

Limited Liability Company l l l An LLC is a separate entity from its owners (members) LLCs provide members with limited liability LLCs can choose to be taxed as partnerships or corporations for federal tax purposes (singlemember LLC cannot be taxed as partnership) Ownership structure allows different classes of ownership with different voting rights Forming an LLC is a more formal process than forming a partnership and may be more costly © 2005 Prentice Hall, Inc. 10 - 13

PLLC l l l The professional limited liability company is a professional service organization using the LLC form PLLCs protect members from liability for malpractice of other members PLLCs also protect members from general liabilities of the business (similar to corporate shareholders) © 2005 Prentice Hall, Inc. 10 - 14

Partners Cannot Be Employees l General partners, managing LLC and other active LLC members are considered selfemployed individuals and required to pay selfemployment tax on net income passed through to them Ø l Limited partners and LLC members who are only investors do not pay self-employment tax Partners and LLC members cannot be employees and are not eligible for tax-free employee fringe benefits © 2005 Prentice Hall, Inc. 10 - 15

Entity vs. Aggregate Concept l Entity concept – views the partnership as separate from the partners Ø l Partner can sell property to partnership and recognize gain or loss on sale Aggregate or conduit concept – views the partnership as an extension of the partners Partners are liable for debts of the partnership Ø Partners share gains and losses from operations Ø © 2005 Prentice Hall, Inc. 10 - 16

Partner’s Capital Account l l Each partner’s capital account will show the partner’s claim on the net book value of the partnership assets. The difference between the partner’s capital account and partner’s tax basis is due to the unrecognized (deferred) gain or loss on property contributed © 2005 Prentice Hall, Inc. 10 - 17

Partner’s Interests l l A partner has a proportionate interest in the partnership assets A partner has a right to share in a percentage of the partnership's profits and losses Ø Ø Share of income or loss is determined by the provisions of the partnership agreement If no provision is specified, partners are assumed to share profits and losses equally © 2005 Prentice Hall, Inc. 10 - 18

Partnership Tax Year l Profits and losses flow through to partners on the last day of the partnership’s tax year Ø l Partners report their share on their tax return in the year in which the partnership tax year ends Partnership tax year is one of following Tax year of its partners who own majority Ø Year of all the principal partners (owning more than 5% interest) Ø Month that provides least aggregate deferral of income Ø Natural business year (no more than 3 -month deferral of flow-through items) Ø © 2005 Prentice Hall, Inc. 10 - 19

Operating Results l Form 1065, information return, includes Schedule K (and K-1 for each partner) which shows separately stated items and aggregate income or loss Separately stated items are those that cannot be aggregated into net income because they are subject to some special treatment or limitation at the owner level Ø Partnership net income is the aggregate of all items that are not separately stated Ø © 2005 Prentice Hall, Inc. 10 - 20

Separately Stated Items l l l l l Capital gains and losses Section 1231 gains and losses Dividends and interest (and related expenses) Section 179 deductions Charitable contributions Medical and dental expenses paid by partnership for partners Passive income AMT preferences and adjustment items Self-employment income © 2005 Prentice Hall, Inc. 10 - 21

Operating Results l Partners must report their share of partnership income even if they receive no distributions from which to pay taxes Ø Partners who need money to pay taxes on income that is passed through should make sure partnership agreement permits withdrawals of cash for this purpose © 2005 Prentice Hall, Inc. 10 - 22

Partner's Basis l Basis determines the Ø Ø l Maximum amount a partner can withdraw tax-free from the partnership Limit on the amount of loss a partner can deduct A partner's basis in his partnership interest begins with his contribution to the partnership Ø © 2005 Prentice Hall, Inc. If property is contributed, partnership interest basis equals the adjusted basis of the property contributed 10 - 23

Partner's Basis l The partner's basis is increased by: Recourse debt—creditor can look only to general partners for repayment on default Ø Partner's share of income (including taxexempt income) Ø Nonrecourse debt—creditor can look only to collateral for repayment on default Ø Partner’s share of liabilities Ø General partner's share in all partnership liabilities Ø Limited partner’s share in nonrecourse liabilities only Ø © 2005 Prentice Hall, Inc. 10 - 24

Partner's Basis l The partner's basis decreased by Ø Reduction in liabilities Ø Partner's share of loss Ø Distributions made to partner l Partner can never have negative basis Ø © 2005 Prentice Hall, Inc. To prevent negative basis, partner recognizes gain equal to the amount by which a cash distribution exceeds basis 10 - 25

General Loss Limitation l If a partner’s share of losses exceeds the partner’s basis Ø Ø © 2005 Prentice Hall, Inc. Partner can only deduct losses to the extent of basis Excess losses are carried forward (indefinitely) to future years until there is sufficient basis against which to deduct the unused losses 10 - 26

At-Risk Rules l l Limit losses by recognizing partners are not at-risk for nonrecourse debt At-risk rules limit deductibility of losses to partner’s basis reduced by nonrecourse debt Ø © 2005 Prentice Hall, Inc. Losses are carried forward until partner has sufficient at-risk basis 10 - 27

Passive Income and Losses l l Passive losses can only be deducted by owner/recipient to the extent there is passive income from a prior year or from another passive activity Passive losses may be deducted against nonpassive income in year activity is completely disposed of © 2005 Prentice Hall, Inc. 10 - 28

Types of Income and Losses l l l Active: salary and wages of an employee and income earned from a business in which the owner/recipient materially participates Portfolio: interest and dividends Passive: tax shelter income, income passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate © 2005 Prentice Hall, Inc. 10 - 29

Material Participation l Current activity level Ø Ø l 500 hours or more participation during year Participation is substantially all the activity by all persons At least 100 hours and no one else participates more At least 100 hours in more than one activity and aggregate of activities exceeds 500 hours Prior activity level Ø Ø Materially participated in 5 of preceding 10 years Materially participated in 3 prior years in personal service activity © 2005 Prentice Hall, Inc. 10 - 30

Rental Real Estate Relief l l Taxpayers can qualify for up to $25, 000 deduction for rental real estate losses Taxpayer must own at least 10% and actively participate in management Ø l Set rents, qualify renters, approve repairs Deduction phases out for AGIs between $100, 000 and $150, 000 © 2005 Prentice Hall, Inc. 10 - 31

Real Property Business Exception l Taxpayers must spend more than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours © 2005 Prentice Hall, Inc. 10 - 32

Partner’s Guaranteed Payment l l A fixed or guaranteed payment (or salary) made to a partner for services or use of capital is treated as a business expense deduction by the partnership and ordinary income to the partner receiving it If the payments are dependent upon partnership operations, they are not guaranteed payments © 2005 Prentice Hall, Inc. 10 - 33

Nonliquidating Distributions l l Distributions are generally tax-free to partners Distributions reduce the partner’s basis Ø Ø Ø © 2005 Prentice Hall, Inc. Reduce basis first for cash received then for basis of other property distributed (partner takes partnership’s basis for property) If cash distribution exceeds partner’s basis, the partner recognizes gain for the excess Loss is never recognized on nonliquidating distributions 10 - 34

Liquidating Distributions l l Gain recognized only if cash received exceeds partner’s basis (same as nonliquidating distribution) A partner may recognize loss only if the total basis of cash and ordinary income property received is less than his partnership basis Ø If partner receives any other property, the partner allocates basis remaining in the partnership interest to that property (and loss is not recognized) © 2005 Prentice Hall, Inc. 10 - 35

Sale of Partnership Interest l Any gain or loss recognized on sale of partnership interest is normally capital gain or loss Ø l l If partnership owns ordinary income assets (hot assets), the sale must be partitioned between the hot assets and all other assets to prevent the partner from converting gain on sale of ordinary income assets to capital gains Any reduction in liabilities is treated as cash received Partnership tax year closes for selling partner © 2005 Prentice Hall, Inc. 10 - 36

S Corporations l l l Qualifying corporations that elect S corporation status use conduit (flowthrough) concept to achieve only one level of tax Profits and losses allocated to shareholders according to the number of shares of stock owned on each day of the tax year Afford shareholders the limited personal liability of a regular corporation © 2005 Prentice Hall, Inc. 10 - 37

S Corporation Requirements l l l Must be a domestic corporation Have only one class of stock outstanding Have no more than 75 shareholders (husband wife are considered one shareholder) Can have only individuals, estates and certain trusts as shareholders Individual shareholders must be either U. S. citizens or resident aliens © 2005 Prentice Hall, Inc. 10 - 38

Electing S Status l File Form 2553 by 15 th day of the 3 rd month of the year in which election is to be effective Ø l l File by March 15, 2005 for calendar year 2005 Prospective election (effective for following tax year) can be made any time IRS has authority to accept late filing if corporation can show reasonable cause © 2005 Prentice Hall, Inc. 10 - 39

Affirmative Termination of the S Election l l A retroactive revocation must be made by the 15 th day of 3 rd month by a simple majority of the shareholders A prospective termination can be made at any time for any future date specified by a simple majority of the shareholders © 2005 Prentice Hall, Inc. 10 - 40

Inadvertent Termination of the S Election l l If the S corporation fails to satisfy any of the S corporation requirements at any time, the election is terminated as of the day before the disqualifying event occurred If termination inadvertent, IRS can allow corporation to continue as S corporation © 2005 Prentice Hall, Inc. 10 - 41

S Corporation Operations l l Determination of net income and separately stated items is similar to partnerships S corporation net income not subject to selfemployment taxes Ø Ø l Employment taxes paid only on salaries Shareholder cannot participate in employee fringe benefits if ownership is greater than 2% Form 1120 S reports operations Ø Income and loss allocated on number of days ownership and number of shares owned © 2005 Prentice Hall, Inc. 10 - 42

Loss Limitations l Limitations on loss deductions for shareholders similar to those for partners Ø Ø Ø l Shareholder must have basis Shareholder must be at-risk If losses are passive, passive rules apply Liability treatment very different from partnership Ø Ø No basis increase for any corporate liability Shareholder can deduct loss to the extent of basis in debt for money loaned directly to corporation © 2005 Prentice Hall, Inc. 10 - 43

Stock Basis l Each shareholder must keep track of stock basis similar to tracking a partnership basis Basis begins with contribution to capital or purchase of stock Ø Increased for income and gains and reduced first for distributions and then for deductions and losses (including nontaxable income and expenses), but not below zero Ø Distributions are tax-free if they do not exceed basis; gain recognized if distribution exceeds basis as if stock is sold for excess Ø © 2005 Prentice Hall, Inc. 10 - 44

AAA l Accumulated adjustment account – a corporate account that tracks a corporation’s undistributed but previously taxed earnings The positive balance in AAA is the measure of the value of cash and property that can be distributed to shareholders without additional tax Ø Unlike basis, AAA may be negative from losses (but distributions cannot make AAA negative) Ø © 2005 Prentice Hall, Inc. 10 - 45

Property Distributions l l l Corporation recognizes gain on distribution of appreciated property Loss on depreciated property not recognized Shareholders increase their stock basis for the gain recognized (unrecognized loss does not reduce basis) Basis is then reduced for FMV of distributed property Shareholders use FMV for basis of all property received © 2005 Prentice Hall, Inc. 10 - 46

Schedules M-1 and M-2 l l Schedule M-1 reconciles book to tax income and is similar to C corporation’s M-1 without contribution carryovers or taxes paid Schedule M-2 reconciles AAA account at beginning of year to balance at end of year Ø OAA reconciles items that don’t affect AAA (tax-exempt income and expenses) © 2005 Prentice Hall, Inc. 10 - 47

S Corporation Taxes l l Under normal circumstances, an S corporation does not pay taxes If it was previously a C corporation, it may pay taxes in a few special cases for Ø Ø Ø © 2005 Prentice Hall, Inc. Built-in-Gains Excess Net Passive Investment Income LIFO Recapture 10 - 48

Redemptions and Liquidations l S corporations follow C corporation rules In a redemption of stock for property, S corporation recognizes gain on distribution of appreciated property (but not loss) Ø Recognized gain flows through to shareholders and increase basis Ø In liquidation both gains and losses are recognized; these gains (losses) flow through and increase (decrease) stock basis Ø © 2005 Prentice Hall, Inc. 10 - 49

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