Sole Proprietorships and Flow-Through Entities

1. Sole ProprietorshipsandFlow-Through Entities Chapter 10

2. Flow-Through Entity A trade or business whose net income is not taxed at the entity level but �flows through� to the owner(s) of the entity for taxation The flow-through form avoids the double taxation associated with the corporate form The character of the items that �flow through� is generally determined at the entity level

3. Flow-Through Entities Sole proprietorship General partnership Limited partnership Limited Liability Company (LLC) Limited Liability Partnership (LLP) S Corporation

4. Sole Proprietorship Single 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; owner has a basis in each business asset Owner must establish that the business is not a hobby

5. Sole Proprietorship Owner uses Schedule C (or C-EZ) to report proprietorship income and expenses Transactions that are not included in business operating income include Income and expenses from investments Capital gains and loses Section 1231 gains and losses Charitable contributions

6. Sole Proprietorship When a sole proprietor maintains an office in the home Allocated space must be used exclusively and on a regular basis for the business Deduction is limited to taxable income from business after deducting all other business expenses Home office expenses are separately reported on Form 8829

7. Sole Proprietorship Sole proprietor cannot be an employee of the business Sole proprietor not eligible for tax-free employee fringe benefits. Sole proprietor can Deduct own health insurance premiums for AGI Deduct contribution to own retirement account for AGI Hire spouse as employee and spouse can then participate in fringe benefits

8. Self-Employment Taxes Self-employed individuals (sole proprietors, general partners, and managing members of LLCs) must pay self-employment taxes (Social Security and Medicare) Deduction for 50% of self-employment tax allowed for AGI

9. Partnerships 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 No restrictions on who can be a partner (e.g., an individual, another partnership, a corporation, an estate, or a trust can be a partner in a partnership) Most LLCs are treated as partnerships for tax purposes

10. General Partnership General partnerships have only general partners General partners: Are personally liable for all debts of the partnership Have an active role in management Have the authority to bind the partnership with respect to third parties

11. Limited Partnership Limited partnerships have at least one general partner and at least one limited partner Limited partners liability for partnership obligations is limited to invested capital. Additionally, limited partners Are not permitted to have an active role in the management of the partnership Do not have the authority to bind the partnership with respect to third parties

12. Limited Liability Partnership 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 However, partners are protected from liability for malpractice of other partners

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

14. PLLC The professional limited liability company is a professional service organization using the LLC form PLLCs protect members from Liability for malpractice of other members General liabilities of the business (similar to corporate shareholders)

15. Partners as Employees General partners, managing LLC members, and other active LLC members are considered self-employed individuals, required to pay self-employment tax on net income passed through to them 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 most tax-free employee fringe benefits

16. Entity vs. Aggregate Concept Entity concept � Views the partnership as separate from the partners 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 Partners share gains and losses from operations

17. Partner�s Capital Account 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 in their partnership interest is due to the unrecognized (deferred) gain or loss on property contributed

18. Partner�s Interests 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 Share of income or loss determined by the provisions of the partnership agreement If no provision is specified, partners are assumed to share profits and losses equally

19. Partnership Tax Year Profits and losses flow through to partners on the last day of the partnership�s tax year 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 interest Year of all the principal partners (owning more than 5% interest) Month that provides least aggregate deferral of income Natural business year (no more than 3-month deferral of flow-through items)

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

21. Separately Stated Items 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

22. Operating Results Partners must report their share of partnership income even if they receive no distributions from which to pay taxes Partners who need cash to pay taxes on income that is passed through should make sure partnership agreement permits withdrawals of cash for this purpose

23. Partner's Basis A partner�s basis in the partnership interest Dictates the maximum amount a partner can withdraw tax-free from the partnership Limits the amount of loss a partner can deduct A partner's basis in the partnership interest begins with his contribution to the partnership If property is contributed, partner�s basis equals the adjusted basis of the property contributed if no liabilities are assumed by the partnership

24. Partner's Basis The partner's basis is increased by: Partner's share of income (including tax-exempt income) Partner�s share of liabilities assumed on contribution of property or otherwise undertaken General partner's share in all partnership liabilities Limited partner�s share in nonrecourse liabilities Recourse debt - Creditor can look only to general partners for repayment on default Nonrecourse debt - Creditor can look only to collateral for repayment on default

25. Partner's Basis The partner's basis is decreased by: Partnership�s assumption of liability on contributed property Reduction in partnership liabilities Partner's share of loss Distributions made to partner A partner can never have a negative basis � To prevent negative basis Partner recognizes gain if liabilities assumed by partnership exceed partner�s basis in property contributed Partner recognizes gain equal to the amount by which a cash distribution exceeds basis

26. General Loss Limitation If a partner�s share of losses exceeds the partner�s basis 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

27. At-Risk Rules Limits loss recognition by partners who are not at-risk for nonrecourse debt At-risk rules limit deductibility of losses to partner�s basis minus nonrecourse debt Losses are carried forward until partner has sufficient at-risk basis

28. Passive Loss Rules The passive income (loss) rules limit deduction of losses by passive investors, which includes limited partners Passive losses can only be deducted against income from other passive investments Passive losses cannot be deducted against active income (e.g., salaries) or portfolio income (e.g., interest and dividends)

29. Guaranteed Payments A guaranteed payment is a distribution a partnership is obligated to make to a partner for the performance of services or for the use of capital. Treated as Business expense deduction by the partnership Ordinary income to the partner receiving the payment If the payments are dependent upon partnership operations, they are not guaranteed payments

30. Nonliquidating Distributions Distributions are generally tax-free to partners Distributions reduce the partner�s basis 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 excess triggers gain recognition Loss is never recognized on nonliquidating distributions

31. Liquidating Distributions 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 If partner receives any other property, the partner allocates basis remaining in the partnership interest to that property (and loss is not recognized)

32. Sale of Partnership Interest Any gain or loss recognized on sale of partnership interest is normally capital gain or loss 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 ordinary income into capital gain Any reduction in liabilities is treated as cash received Partnership tax year closes for selling partner

33. S Corporations An S Corporation Is a regular corporation for legal purposes Is a flow-through entity (single level of tax) for federal tax purposes Affords shareholders the limited personal liability of a C Corporation S Corporation profits and losses are allocated to shareholders according to the number of shares of stock owned each day of the tax year

34. S Corporation Requirements Must be a domestic corporation Have only one class of stock outstanding Have no more than 100 shareholders (family members 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

35. Electing S Status In order to become an S Corporation, a qualifying C Corporation must File Form 2553 by 15th day of the 3rd month of the year in which election is to be effective File by March 15, 2008 for calendar year 2008 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

36. S Election - Affirmative Termination A retroactive revocation must be made by the 15th day of 3rd 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

37. S Election - Inadvertent Termination If the S Corporation fails to satisfy any of the S Corporation requirements (e.g., exceeding the 100 shareholder limit), the election is terminated as of the day before the disqualifying event occurred If the termination is inadvertent, IRS can allow corporation to continue as S Corporation

38. S Corporation Operations Determination of net income and separately stated items similar to partnerships S Corporation net income not subject to self-employment taxes Employment taxes paid only on salaries Greater than 2% shareholders cannot participate in employee fringe benefits Form 1120S (includes Schedule K and Schedule K-1s for shareholders) reports operations Income and loss allocated on number of days ownership and number of shares owned

39. Loss Limitations Limitations on loss deductions for S Corporation shareholders similar to those for partners Liability treatment very different from partnership No basis increase for any corporate liability Shareholder can deduct losses to the extent of basis in debt for money loaned directly to corporation

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

41. AAA Accumulated Adjustment Account (AAA) � A corporate account that tracks an S 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 Unlike basis, AAA may be negative from losses Distributions cannot create or increase a negative AAA

42. Property Distributions S Corporation Recognizes gain on distribution of appreciated property Does not recognize loss on depreciated property Shareholders Increase stock basis for the gain recognized Unrecognized losses reduce basis Basis is then reduced for FMV of distributed property Shareholders use FMV as basis of property received

43. Schedules M-1 and M-2 Schedule M-1 reconciles book to taxable income 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 OAA reconciles items that do not affect AAA (tax-exempt income and expenses)

44. S Corporation Taxes Under normal circumstances, an S Corporation does not pay taxes If the S Corporation was previously a C Corporation, taxes made be paid for Built-in gains Excess Net Passive Investment Income LIFO recapture

45. Redemptions and Liquidations S Corporations follow C Corporation rules In a redemption of stock for property, S Corporation recognizes gain on distribution of appreciated property (no loss recognition for depreciated property) Recognized gain flows through to shareholders and increases basis In liquidation, both gains and losses are recognized; these gains (losses) flow through and increase (decrease) stock basis

46. U.S. Production Activities Deduction for qualified production activities available to flow-through entities engaged in US production activities In 2007, deduction is 6% of income from qualifying activities Deduction determined at the owner level, based on owner�s share of qualifying production activities income 50% of W-2 wages limitation is applied at entity level

47. Passive Income and Losses Passive losses can only be deducted by owner/recipient to the extent of passive income from a prior year or from another passive activity Passive losses may be deducted against nonpassive income in the year an activity is completely disposed of

48. Types of Income and Losses 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

49. Material Participation To be exempt from the passive loss limits, one of the following material participation standards must be met Current activity level 500 or more hours 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 Materially participated in 5 of preceding 10 years Materially participated in 3 prior years in personal service activity

50. Rental Real Estate Relief Taxpayers can qualify for up to $25,000 deduction for rental real estate losses Taxpayer must own at least 10% of the rental activity and actively participate in management Actively participate? Set rents, qualify renters, approve repairs Deduction phases out for AGI between $100,000 and $150,000

51. Real PropertyBusiness Exception Taxpayer may deduct loss currently if: Taxpayers spends more than half their time in real property businesses in which they materially participate and Time spent equals or exceeds 750 hours Usually eliminates persons who hold full-time positions in other occupations

52. The End