Principles of Taxation

1. Principles of Taxation Chapter 9 Sole Proprietorships, Partnerships, and S Corporations

2. Objectives • Explain effect of sole proprietorship on individual tax return. • Describe requirements for home office deductions. • Compute FICA taxes and self-employment taxes. • Distinguish general and limited partnerhips. • Differentiate between partnership distributive income versus cash flow. • Compute partnership adjusted basis. • Determine eligibility for S Corporation status. • Constrast basis limits for S Corporations versus partnerhips.

3. Business Organizations • Taxpayer = owners = flow-through entities • sole proprietorship • partnerships • LLCs • S Corporations • Taxpayer = corporation • C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).

4. Sole proprietorship • Business income and expenses are reported on Schedule C, filed with the individual form 1040. • Net income or loss on Schedule C is ordinary income or loss; combine this net with other items of gross income. • If the Schedule C business loss > other sources of income, the NOL (net operating loss) can be carried back 2 years and forward 20 years.

5. Sole proprietorship • Special reporting rules: • Interest, dividends and rent income related to owner’s investments are not reported on Schedule C. See Schedules B and D instead. • Dispositions of business assets are reported on Forms 4797 and Schedule D. • Interest expense on business debt IS deducted on Schedule C. Non-business interest expense MAY be deductible if it is for investments or home mortgages. See Chapters 15 and 16.

6. Home office deduction • A portion of the taxpayer’s personal residence MAY be allowable as a Schedule C deduction IF: the office is used exclusively on a regular basis • 1) as the principal place of business operated by the homeowner, OR • 2) as a place to meet with patients, clients or customers. • A home office used exclusively for administrative or management activities qualifies as a principal place of business if the taxpayer has no other fixed location where such activities are conducted.

7. Home office deduction • If the office qualifies under above rules: • Allocate expenses between business and personal use. For example: • utilities • home mortgage interest and taxes • insurance • repairs • depreciation. • Home office deduction cannot exceed taxable income of the business before this deduction. See AP2.

8. Employment taxes • FICA = 6.2% Social Security tax (on wages up to $72,600 in 1999) + 1.45% Medicare tax on all wages. Both employer and employee must pay this tax. • Employers withhold income taxes and the employee’s share of FICA. • Employers must remit the withheld taxes to the federal (and state if applicable) governments. • Self-employed taxpayers must pay SE (self-employment) tax, equal to 2 x FICA, or 15.3% of net earnings from self-employment. (See footnote 20 for details). 1/2 of SE tax is deductible on Form 1040.

9. Partnerships • The partnership agreement stipulates rights and obligations of partners and the % of profits and losses allocable to each partner. Such agreements permit large flexibility. • General partnership: all partners have unlimited liability • Limited partnership: one or more limited partners are only liable for their contributed capital. Legally, all limited partnerships have at least one general partner. • Limited liability company (LLC). Treated as a partnership for tax purposes but every owner has limited liability.

10. Partnership reporting • The partnership files an information return, Form 1065. • Included with the Form 1065 are Forms K-1, which show EACH partner’s share of income and deductions. • EACH partner reports his or her share on partnership income on Schedule E, as part of his or her Form 1040. • Because the partnership does not pay tax, but each partner reports income and loss, the partnership is referred to as a FLOW-THROUGH ENTITY.

11. Guaranteed payments • A guaranteed payment is a special allocation of ordinary income to the partner receiving it - similar in nature to a salary. • The receiving partner reports as ordinary income BOTH: • 1) his guaranteed payment • 2) his share of partnership income after the guaranteed payment. • Other partners report their shares of partnership income after the guaranteed payment.

12. Guaranteed payment example • Robert, John and Joseph form the RJJ partnership. Robert will do most of the work, so he will receive a guaranteed payment of $25,000 per year. The partners agree to share any remaining income 1/3 each. • RJJ earns $85,000 during the year. • Robert reports $45,000 of partnership income ($25,000 + 1/3 x $60,000). • John and Joseph each report $20,000 of partnership income (1/3 x $60,000).

13. Self-employment income from partnership • SE tax must be paid on • Guaranteed payments + • Distributive share of ordinary business income from partnership • Limited partners do NOT pay SE tax on share of ordinary income.

14. Partnership basis • These things increases basis: • Contributions (initial and ongoing): cash + adjusted basis contributed • Positive income (taxable and tax-exempt) • Share of partnership liabilities for which partner is liable. (Also allow nonrecourse real estate loans for limited partners). • These things decrease basis: • Distributions • Losses and deductions (and shares of nondeductible expenses).

15. Partnership losses limited to basis • Partners CANNOT deduct losses in excess of basis. See AP13, 14 • Excess losses are carried forward indefinitely until additional basis is restored • by additional contributions or additional positive income. • This rule applies to EACH partnership separately. • Are there questions about examples in the text? This can be complicated.

16. S Corporations • Legally a corporation under state law. • An S Corporation is a flow-through entity for tax purposes. • Income and loss items are allocated among shareholders based on their % ownership of stock (this allocation is not flexible like partnership agreements). • Flow-through items retain their character on the individual tax return (e.g. ordinary income, capital losses, charitable contributions, etc).

17. S Corporation eligibility • Only individuals, estates and some trusts may be shareholders. • The number of shareholders (not including spouses) is limited to 75. • The corporation may only have one class of outstanding common stock. • Shareholders must unanimously elect S Corp status.

18. Shareholder basis • Initial basis = cash + adjusted basis of contributed property. • Loan FROM a shareholder to S Corp increases basis for THAT shareholder. Any other debt of the S Corp does NOT increase shareholder basis. (E.g., a bank loan guaranteed by shareholder does not increase basis for any shareholder, even the one that guaranteed the loan). See AP19, 20 • Like partnerships, basis is increased by contributions and income items. Basis is decreased by distributions and loss items.

19. S Corporation operation • Shareholders can be paid a salary. The salary is subject to payroll taxes and reduces ordinary income of the S Corporation. • Share of ordinary income is NOT subject to Self-Employment tax. • Allocable share of loss items can only be deducted up to BASIS, like with partnerships. Losses in excess of basis are carried over until the shareholder has basis again.

20. Other entities • Limited Liability Company. • Treated as a corporation for liability purposes, but as a partership for federal tax purposes. • Limited Liablity Partnership. • A partnership in which each partner’s liability is limited to his or her own actions. Used by professional service firms.